Circle One Inflation video special: What to expect and how to position
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Thought of the day

The first-quarter US earnings season has kicked off with mixed results from several of America's largest banks. While Citigroup and Goldman Sachs reported higher-than-expected earnings, both JPMorgan Chase and Wells Fargo unveiled lower-than-forecast net interest income.

This comes at a time when US equity valuations have been well above historical norms. The S&P 500 is trading at 20 times analysts' 12-month forward earnings forecast, versus an average of closer to 15 times since 1985. Even after the recent setback, the S&P 500 is still up around 16% over the past six months. In addition, rising yields make stocks look less attractive relative to government bonds, amid concerns that the Federal Reserve will keep rates higher for longer. On Monday, the yield on the 10-year US Treasury closed 8 basis points higher at 4.6%, the highest level since November, after strong retail sales data further dampened hopes over the timing and pace of Federal Reserve cuts.

Despite these potential headwinds, we believe the risk of a significant sell-off is manageable and that upcoming profit releases should support the market.

Earnings growth to broaden out beyond the Magnificent 7. America’s top seven growth and tech firms collectively accounted for all of the US market's profit expansion over the past four quarters. We expect this to change in the first quarter. This partly reflects a positive economic backdrop, with surveys pointing to a renewed improvement in manufacturing sentiment at the same time as banks are easing lending standards-both of which have a good correlation to S&P profits. Once the final results are tallied, we think the S&P 500, excluding the Magnificent 7, will post its first quarter of positive, albeit modest, profit growth since the fourth quarter of 2022.

Ultimately, these improving profit trends should trickle down to small-cap companies. Sluggish profit growth has been one of the key reasons that small-caps have lagged large-caps over the last several quarters. In the absence of stronger profit trends, the rise in long-term interest rates this year has had a disproportionately negative impact on small-cap stocks-which rely more on floating-rate debt. But with rates likely to fall from here as inflation ultimately cools and the Fed starts to cut rates, long-term interest rates should still decline, which would be favorable for small-caps. Last week we revised our outlook for rate cuts in 2024 from three to two. We maintain our most preferred view on small-caps due to the bottoming in manufacturing sentiment, still-healthy but slowing growth, and falling rates, in conjunction with attractive valuations.

The surge in AI investment continues to have strong momentum, with the semiconductors needed to deploy AI likely to remain supply constrained through the balance of this year. But this is not just a semiconductor story. It affects everything from networking equipment and electrical infrastructure, to heating and air conditioning systems. At the same time, tech end-markets such as smartphones, personal computers, and servers also appear to be improving. Away from tech, capital market activity has been improving (good for the banks), industrial end-markets such as aerospace remain robust, and freight volumes are picking up, while the housing market has also shown signs of recovery.

So, although we will carefully monitor risks, we remain neutral on US equities, meaning that investors should maintain allocations in line with their long-term financial plan. This outlook should be supported by a healthy earnings season. We expect earnings per share growth of 7–9% for the first quarter, consistent with our full-year target of 9% for 2024. Our S&P 500 price targets for June and December are 5,100 and 5,200, respectively, compared to 5,062 at the end of trading on 15 April. In our upside scenario, we think the S&P 500 could reach 5,500 by the end of the year. That outcome would likely be achieved if inflation pressures ease more quickly or corporate profit growth is stronger than expectations.