Earnings and Artificial Intelligence Save Stocks Despite Inflation

Earnings momentum picked up last week, with 159 S&P 500 companies reporting, and will be the busiest week yet with 175 scheduled to report. A more diversified company mix boosted earnings expectations for the quarter, after a relative drag from bank and healthcare earnings in previous weeks. A more detailed preview of the earnings season is available here.

The S&P 500 gained 2.7% for the week, up 7.4% year-to-date. The yield on the 10-year Treasury rose to 4.62 percent from 4.66 percent, leading the Bloomberg Aggregate Bond Index to fall 0.1 percent. After a tough last week, Magnificent 7 rose nearly 6 percent. Magnificent 7 includes Microsoft.
Microsoft
(MSFT), Meta Platforms
Meta platforms
(META), Amazon.com (AMZN), Apple
apple
(AAPL), NVIDIA
NVIDIA

SPDR Dow Jones Industrial Average ETF Trust
(NVDA), Alphabet (GOOGL), and Tesla
Tesla
(TSLA).

Notable gainers this week include McDonald's (MCD), Starbucks.
Starbucks
(SBUX), Coca-Cola
Coca Cola
( KO ), Amazon.com ( AMZN ), Eli Lilly ( LLY ), Apple ( AAPL ), and Berkshire Hathaway
Berkshire Hathaway
(BRK/A, BRK/B).

At about halfway through the reporting season, blended earnings, which actually align with companies' estimates, matched forecasts at the end of the quarter.

The main driver of the earnings improvement came from the communications services sector, primarily due to earnings beats by Meta Platforms ( META ) and Alphabet ( GOOGL ). The industrials, technology, and consumer discretionary sectors also beat first-quarter earnings estimates, according to FactSet.

Earlier in the season, the healthcare sector was penalized for the accounting treatment of ongoing research and development from the acquisitions of Bristol-Myers Squibb (BMY) and Gilead Sciences.
Gilead Sciences
(GILD). According to FactSet, expected earnings from Merck ( MRK ) and Gilead Sciences boosted the expected earnings growth rate for the healthcare sector to -28.1% from -30.5%.

Sales growth is closely related to nominal GDP growth, combining post-inflation economic growth (real GDP) with inflation. With nominal GDP growth solid year-on-year for the first quarter, there should be a tailwind in top-line revenue growth for companies. Sales growth improved last week and exceeded expectations in the earnings season.

So far, consolidated earnings performance has underperformed expectations at the end of the quarter. Combining actual results with the consensus estimates of companies reporting so far, the diluted earnings growth rate for the quarter is in line with expectations at the end of the quarter of +3.5%.

Although last week's first-quarter GDP growth of 1.6% was below consensus estimates of 2.5%, the details were more important than the headline. Excluding the more volatile components of inventories and net exports, which have been dampened by first-quarter GDP growth, domestic demand appears robust. Real final sales to private home buyers, which measure private demand in the domestic economy, were healthy at 3.1 percent in the first quarter after rising 3.3 percent in the fourth quarter.

While the GDP report should not be a concern about economic growth, the inflation component was more worrisome. Inflation as measured by the Federal Reserve's preferred measure, core PCE, edged up to 3.7% quarter-on-quarter on an annualized basis.

Inflation surprises and continued economic growth reduced the odds of a June Federal Reserve (Fed) rate cut to less than 15%. The chance of a rate cut in July is now one in three. The probability of a cut fell to less than 75 percent at the September meeting. Expected rate cuts in 2024 to one. Based on these expectations, the 2-year Treasury yield is 5% after falling to 4.1% in January.

The last mile of the Fed's fight against high inflation remains a stumbling block for stocks as yields rise and the belief around economic easing is challenged. On the positive side of the ledger, the resilient economic growth revealed by last week's GDP report continues the dividend return story. Also, the promise of artificial intelligence (AI) was bolstered by earnings from Microsoft ( MSFT ) and Alphabet ( GOOGL ). While Meta Platforms ( META ) fell as investors were disappointed by expected spending on AI capital spending in the future, it reinforced expectations for more spending on artificial intelligence technology.

The busiest earnings week includes some bellwethers like Apple and Amazon.com that will be closely watched. The Fed meeting with no change in short-term interest rates is virtually assured, but Chair Powell's comments will be scrutinized for Fed rate hikes in the wake of tepid inflation data. Hints about the timing of the cut. With the focus on inflation and the Fed in data-dependent mode, Friday's monthly payrolls report will be noteworthy. Additionally, Berkshire Hathaway's annual meeting takes place on Saturday with highly anticipated comments from Warren Buffett.