The U.S. economy is navigating a complex but promising phase, with recent data releases reflecting a nuanced yet optimistic outlook. U.S. economic data released in the past few weeks has generally aligned with the softer activity and labor market data observed recently. The icing on the cake was the June CPI report, showing the stickier components finally started to ease. This leaves September as a live meeting for the Federal Reserve with markets assigning about a 95% probability to the Federal Open Markets Committee starting to reduce rates.

Retail sales have been better than expected and spending on services remains robust, indicating resilient consumer behavior. Industrial production saw a significant uptick in June and preliminary PMI data suggests that this positive momentum likely continued. The housing market faces challenges from higher interest rates and limited supply. Yet the overall economic trajectory appears poised to align with long-term growth trends in the second half of 2024.

In this context, we are confident that the Federal Reserve will begin easing monetary policy, creating a more favorable environment for risk assets.

Retail, housing and jobs: A nuanced picture

June retail sales exceeded expectations, leading estimates for 2Q real consumer spending higher as a result. The report should ease concerns about a sudden downshift in consumer spending. June’s total nominal retail sales and food services spending were unchanged (due to declines in motor vehicles and gas stations) but spending excluding these categories surged by a robust 0.8% month-over-month (m/m). The control category (excluding auto, gas, building materials and food services) increased 0.9% m/m. Meanwhile, both May and April retail sales data were revised higher. Furthermore, alongside the promising consumer prints, a rise in corporate spending, on capital goods and building materials, suggests that business fixed investment may accelerate.

Housing, on the other hand, remains under pressure. Housing starts and permits surpassed expectations in June, rising 3.0% and 3.4%, respectively. The improvement was driven primarily by the volatile multifamily segment; single-family components declined. This rebound in multifamily construction is likely due to rising inventories of single-family homes. Despite the June uptick in starts and permits, however, both were significantly down for the second quarter. Total housing starts dropped 16% quarter-over-quarter (seasonally adjusted average rate) and permits fell 22%, signaling a near-term drag on residential investment.

The June employment data presents a nuanced picture of the U.S. labor market, marked by both strengths and areas of concern. Payroll growth is decelerating and the unemployment rate is inching higher, yet wage growth remains somewhat elevated. High-frequency employment indicators, such as initial and continuing jobless claims, are trending upward, consistent with a gradually cooling labor market.

Nonfarm payrolls exceeded expectations, driven primarily by government employment, while private payrolls came in below estimates. The unemployment rate rose modestly in June, to 4.1%, considered a "good" increase because it was due to labor force expansion (Exhibit 1). Temporary help service jobs saw a notable decline but overall employment in the services sectors, such as leisure and hospitality, continued to grow, albeit at a slower pace. Average hourly earnings increased slightly and weekly hours decreased slightly.

Interrupting the broader cooling trend in labor demand, the May Job Openings and Labor Turnover Survey (JOLTS) showed a rise in job openings. Yet hiring rates also ticked up and the quits rate remained stable, suggesting modest downward pressure on wage growth. Furthermore, although jobless claims have settled into a higher range compared to earlier this year, they are still comparable to last summer's levels.

The June survey data presented a mixed but cautiously optimistic picture. The flash U.S. June Composite PMI exceeded expectations, at 55.1, driven by a rise in the services component. The manufacturing PMI also saw a modest increase, to 51.7, as new orders and employment rose, although output and prices declined. 

The ISM manufacturing index sent a different signal, declining on weakness in production and output. Importantly, however, both reports indicated some positive momentum with an increase in new orders and easing prices.

In the services sector, reports diverged: The ISM index dropped to 48.8, the lowest since 2020, whereas the S&P PMI rose to 55.3, a two-year high. The ISM business activity and new orders indices saw significant declines but the PMI showed improved new business activity and employment.

How do you get stronger earnings with weaker growth?

But what does a backdrop of moving toward more trend-like growth mean for profits? Interestingly, the significantly heightened expectations seen in the second quarter of 2024 present the greatest challenge since 2021 to surpassing consensus EPS growth estimates. However, earnings revision ratios and pre-announcements do not indicate a significant risk of negative EPS surprises. And negative preannouncements are lower than in the last two quarters.

Importantly, we think more reasonable Magnificent 6 earnings growth projections make 8% EPS growth achievable. Earnings growth in Q2 looks set to be driven primarily by the Mag 6 companies, with a broadening of this growth to other companies expected in the second half of the year. The risk that margins could surprise to the downside is lower for the Mag 6 than the S&P 500’s other 494 companies. Year-over-year (y/y) margins are projected to expand moderately in Q2 and more robustly in the second half, with core operating margins expected to increase by 64 basis points y/y in Q2. That leaves them on track to return to pre-COVID highs by the end of the year.

At writing time, the Q2 earnings season had kicked off with reports from the largest U.S. banks, which have generally showed strong capital markets activity but still sluggish loan growth. More broadly, S&P 500 operating EPS is currently tracking USD 58.24, representing 6.2% y/y growth. Pro forma EPS is tracking at USD 59.20, indicating 8.6% y/y growth, and seven of 11 sectors are expecting positive pro forma earnings growth in Q2. The most significant source of earnings growth, in Q2 and the coming quarters, is expected to be the Communication Services and Technology sectors. Ongoing cost-cutting efforts by many of the other 493 S&P Index companies are improving earnings, bolstered by favorable base effects.

While growth stocks are expected to continue their robust profit growth, pro forma earnings are set to contract in the Energy, Materials and Industrials sectors. In Financials, sluggish loan growth will likely drag on net interest income, but improvement in the Insurance and Capital Markets business segments should support earnings growth. Healthcare shares are expected to post earnings growth of 18.0% y/y as the sector recovers from 2023’s earnings recession. Within the consumer sectors, businesses that have embraced Americans’ rising price sensitivity look positioned to generate the best results.

Asset class implications

We expect that a broadening of earnings growth beyond the Magnificent 6 should support opportunities in the more value-oriented parts of the U.S. equity market. Furthermore, while small cap equities are performing better, we consider this more of a tactical, rather than structural, opportunity. The market has consistently rewarded earnings this cycle, leaving us to “follow the profits” when evaluating opportunities in U.S. equities. Given our constructive outlook on the economy and monetary policy, we are overweight equities and credit, and modestly underweight duration, in our multi-asset portfolios.

09rs242407181040