Macro uncertainty is high, but the earnings season has been solid—and not only in the U.S.

It has been challenging to make sense of current economic and market news.

Economists’ forecasts have been unusually wide of the mark on some recent data releases. The messages coming out of those releases are often contradictory. We see a notably wide dispersion of top-down outlooks among our own portfolio managers and analysts. In addition, we face two major “hot” wars, a growing “cold” war, and the highest ever number of voters, globally, going to the polls during 2024. It has been rare in recent economic history to see such a head-spinning picture.

In this kind of environment, we believe risk management becomes paramount. Rather than spending enormous amounts of time contemplating whether a soft, hard or no landing is ahead, consider thinking about where risk lies, and what could drive risk assets meaningfully higher or lower.

Risks in the Economy

On the economy, last week’s Perspectives from Shannon Saccocia did a good job of identifying where we think the risk lies.

Should inflation and interest rates prove stickier than expected, those on middle incomes may begin to cut back on their spending. Companies may then struggle to sustain margins in the face of rising labor and borrowing costs. Should they respond with layoffs, consumer sentiment could sour further and trigger a downward spiral into a hard landing.

We therefore think it is important to acknowledge slowing U.S. retail sales and industrial production, as well as the downturn in leading indicators for the jobs market, such as the Conference Board’s survey of CEOs’ expectations for future layoffs. China, Germany, Japan and the U.K. are among major world economies already in recession or stagnating.

Ultimately, we think inflation and rates are broadly heading down. U.S. unemployment remains very low, jobs growth has been strong and fourth-quarter U.S. GDP growth ran at a remarkable clip of 3.3%. The Atlanta Fed’s GDPNow model suggests that growth is still running at 2.9% for the first quarter—resilient, albeit down from a high of 4.2% a few weeks ago.

But it is precisely this “Goldilocks” scenario of declining inflation, low unemployment and resilient growth that, in our view, creates some risk of disappointment.

The Positives From Fourth-Quarter Earnings

While the macro environment is fascinating to debate, we think the rubber meets the road with earnings. So, what did we learn from fourth-quarter corporate earnings?

The spotlight was on Nvidia last week. Its earnings were up almost 500% year-over-year; sales were up 265%. Moreover, projected revenues for the current quarter also far exceeded analysts’ estimates, as CEO Jensen Huang cited a “tipping point” in chip demand from artificial intelligence.

Nvidia was not the only positive story this season. Perhaps reflecting modest expectations and the uncertainty around the economic background, more S&P 500 companies beat analysts’ earnings estimates than in the previous four quarters. Year-over-year earnings growth for the S&P 500 Index is now expected to be around 7%.

Those all-important margins also easily beat analysts’ expectations, accounting for most of the upside surprise in earnings. While some companies’ commentary flagged wage-growth risk and some cautious consumer behavior, fourth-quarter data showed little sign of an inflation-induced buyers’ strike.

Risks in the Equity Market

Where do we see the risks? In the narrowness of the earnings performance.

While overall outperformance of analysts’ estimates has been broad-based, actual growth has not. Led by Nvidia, the “Super Seven” companies grew their earnings by 60% year-over-year, whereas earnings for the rest of the S&P 500 Index declined by 2%.

It may be difficult for the Super Seven to sustain this growth. Analysts currently believe they can keep it up for the first half of 2024 before the outperformance narrows sharply in the third quarter and reverses by the end of the year.

We believe that would have implications for broad index performance; it is notable that, while estimates for fourth-quarter growth have crept up as results have come in, estimates for full-year 2024 earnings have moved down slightly. At $243 per share, the current consensus estimate is still 10% higher than 2023 earnings, but we remain cautious even on that lower outlook. Slowing nominal growth (U.S. real GDP is expected to grow at 2% with inflation around 3%) may require more significant margin improvement.

The bottom line: In our view, to sustain strong U.S. equity market performance, we think it is critical that earnings growth broaden out beyond the top seven stocks.

On pricing and valuation, we have noticed that companies beating analysts’ sales and earnings expectations have seen their stocks outperform the S&P 500 Index to a degree that is in line with the historical average. Misses, on the other hand, have generally been penalized more aggressively than usual. To us, that suggests a market that is priced for perfection—and possibly bracing for disappointments.

Opportunity Among the Laggards?

In our Solving for 2024 outlook, we suggested that the equity market laggards of 2023 might find favor again this year. Investors who are cautious about large-cap U.S. stocks but want to remain exposed to equities might consider some of these laggards.

Among developed markets, Europe has been the major laggard. It is relatively cheap, but for good reason: While the earnings of the S&P 500 Index ex the Super Seven declined by 2% in the fourth quarter, European earnings fell by 11%—and analysts expect them to decline further during 2024.

We think Japan is more attractive. Last week, the Nikkei Index finally passed the level it hit back in 1989, following a lightning start to this year. The economy may be in recession, but fourth-quarter corporate earnings are up 42% year-over-year, with 95% of companies having reported. That is Super Seven-style growth—but starting from a lower, more sustainable base and available for around 15 times forward earnings. Moreover, analysts expect stronger growth from Japan than from the U.S. during 2024.

The current macro environment likely has several twists and turns ahead, and is not without meaningful risks. In our view, however, a resilient U.S. economy, cooler inflation and a likely decline in short-term rates builds a constructive long-term case for equities. Furthermore, our portfolio managers, working in several regions and markets worldwide, remain focused on bottom-up investing and finding companies with attractive earnings outlooks. We believe portfolios built this way can be resilient in nearly all economic environments we envision.

In Case You Missed It

  • Eurozone Consumer Confidence: +0.6 to -15.5 in February
  • U.S. S&P Manufacturing PMI (Preliminary): +0.8 to 51.5 in February
  • U.S. S&P Services PMI (Preliminary): -1.2 to 51.3 in February
  • U.S. Existing Home Sales: +3.1% to SAAR of 4.0 million units in January
  • Eurozone Consumer Price Index (Final): Headline CPI declined to 2.8% year-over-year and Core CPI declined to 3.3% year-over-year in January
  • Eurozone Manufacturing Purchasing Managers’ Index (Preliminary): -0.5 to 46.1 in February

What to Watch For

  • Monday, February 26:
    • U.S. New Home Sales
    • Japan Consumer Price Index
  • Tuesday, February 27:
    • U.S. Durable Goods Orders
    • U.S. Consumer Confidence
  • Wednesday, February 28:
    • U.S. 4Q GDP (Second Preliminary)
    • Eurozone Consumer Confidence
  • Thursday, February 29:
    • U.S. Personal Income and Spending
  • Friday, March 1:
    • ISM Manufacturing Index
    • Eurozone Manufacturing PMI (Final)

    Investment Strategy Team