Q2 Earnings Season Takes on Added Significance as Investors Look for a Broader Market Rally

Last week started rather quiet for markets. However, with Fed Chair Powell on Capitol Hill, key updates on inflation, and the start of the second quarter earnings season on deck, it was unlikely stocks would finish the week off without some reaction. Notably, Mr. Powell told lawmakers the risks to inflation and growth are coming into better balance, while updates on consumer inflation continued to show further progress last month. And while reactions to airline and bank earnings last week were mixed, by the end of the week, investors had started to rotate aggressively into small-cap and cyclical stocks, which could benefit from a soft-landing in the economy. Meanwhile, interest rate cuts could come as soon as September.

Last week in review:

• The S&P 500 Index gained +0.9%. The Index finished higher for the second consecutive week and is up in five of the last six weeks. Further, the S&P 500 has been higher in ten of the previous twelve weeks and is up +36.4% since its low on October 27, 2023.
• The NASDAQ Composite rose +0.3%, up for the sixth straight week.
• The Dow Jones Industrials Average rose +1.6%, rising back above the 40,000 level for the first time since late May on Friday. The Russell 2000 Index surged +6.0% on the week. Following Thursday's weaker-than-expected inflation readings coming out of the June Consumer Price Index (CPI), small-cap and cyclical stocks raced higher to close the week. Both areas have substantially underperformed large-cap growth this year.
• On a monthly basis, headline CPI declined by 0.1% in June, its first monthly decline since July 2022. On an annualized basis, June headline CPI rose +3.0%, while core CPI (ex-food and energy) rose +3.3%. Whether measured monthly or annually, consumer inflation dropped more than expected in June. Lower energy prices, a continued deceleration in owners' equivalent rent, and declining prices across new vehicles, used vehicles, and airfares helped inflation moderate more than expected last month.
• However, June's Producer Price Index stood in somewhat of a contrast to the CPI report, showing inflation at the wholesale level coming in hotter-than-expected.
• In his testimony to Congress, Fed Chair Powell stressed that holding rates too high for too long could jeopardize economic growth. While the Chair stuck close to known committee views and statements on the economy and rate policy, he noted that inflation is not the only risk factor policymakers will need to consider moving forward.
• Given slower-than-expected consumer inflation trends last month and a Federal Reserve appearing more attentive to supporting economic growth and labor conditions, odds of a 25 basis point fed funds rate cut in September jumped to 90% by the end of the week and compared to 72% one week earlier.
• Slowing inflation and increased odds of a rate cut in September sent government bond yields lower on the week.
• The U.S. Dollar Index weakened against major currencies, Gold moved higher, and West Texas Intermediate (WTI) crude fell.
• A preliminary look at July University of Michigan consumer sentiment showed an unexpected drop to its lowest level in eight months. The cumulative effect of high prices was blamed for consumers' sour mood despite easing inflation pressures and a relatively strong labor market.

Was last week's consumer inflation report the "wake-up" call investors needed?

As noted above, easing inflation pressures and the increasing prospects for a September rate cut helped fuel gains across cyclical sectors and smaller-cap stocks last week - areas that have significantly trailed large-cap growth areas this year.

Debate in the market is beginning to increase if further evidence of a soft landing can finally change the narrative for the 493 S&P 500 stocks that aren't a part of the Magnificent Seven. Investors will have to wait and see if last week's improved trends in areas outside of Big Tech are lasting, especially ahead of critical earnings updates over the next few weeks. However, the secular profit drivers in Big Tech that helped fuel the rally across a select group of stocks this year remain a key reason to continue to allocate to the group longer-term, in our view. That said, easing inflation pressures and the prospects of lower interest rates by year-end could finally fuel improved trends across areas of the market that have been left behind. Frankly, we are starting to ask if last week's CPI data was the "wake-up call" the market needed to begin recognizing the value and opportunity that exists in areas outside of Big Tech.

The next few weeks are all about earnings.

The start of the second quarter earnings season has been somewhat underwhelming. While Bank reports from JPMorgan Chase, Citigroup, and Wells Fargo last week mostly met and beat expectations, guidance weighed on sentiment. Notably, PepsiCo and Delta Airlines provided a cautious outlook on the consumer, as U.S. consumers have cut back on snacking, and excess airline capacity is contributing to pressuring pricing power.

The earnings season is always a critical time for financial markets, as corporate updates offer the latest window into an "on-the-ground" assessment of the key fundamentals driving stock prices. However, with major U.S. stock averages at or near all-time highs, valuations across certain pockets elevated, profit expectations high, and investors looking for broader market participation in the rally, the Q2 earnings season takes on added significance.

Thus, the next few weeks of earnings reports could help add fuel to the market rally should aggregate results and outlooks meet expectations. And if results and outlooks fall short, which may be more case-by-case, then investors will likely deal with those instances accordingly. Given that we see overall economic and profit conditions as positive through year-end, increased volatility across broader stock averages (should it occur) could be greeted as a buying opportunity and/or a chance to rebalance portfolios that have drifted away from targets.

The week ahead:

Following the assassination attempt on former President Trump at a campaign rally in Pennsylvania on Saturday, the former president will receive his third presidential nomination at the Republican National Convention this week in Milwaukee. Trump is reported to be doing fine, though the suspected gunman and a spectator were killed in the incident. Republicans and Democrats condemned the violence, with President Biden and former President Trump briefly speaking on Saturday and President Biden addressing the nation from the Oval Office on Sunday.

Markets this week will be focused on the ramp higher in second quarter earnings reports, a June retail sales report, a batch of housing data, the latest Fed Beige Book, and several speeches from Fed officials, including from Chair Powell.

• 45 S&P 500 companies (including 5 Dow 30 components) will report Q2 earnings results this week. Many of the reports will come from Financials, offering further visibility into consumer and business lending as well as into asset management and investment banking trends.
• Retail sales last month are expected to decline month-over-month but remain positive ex-autos and fuel.
• Numerous Fed speeches throughout the week could provide more color on a possible September rate cut.

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