Despite recent strong equity performance, the end of monetary tightening combined with strong nominal GDP growth provide a constructive backdrop for U.S. equities over the remainder of the year.
Equity markets have had a strong start to the year, shrugging off a hawkish repricing in monetary policy expectations and a 5% pullback in April to set 25 new all-time highs. In contrast to last year, market strength has been accompanied by breadth, as solid economic fundamentals have supported a broader earnings recovery and improved investor sentiment. Looking ahead, return expectations should be more modest, but healthy earnings growth and wide valuation dispersion suggest the environment remains positive for equity performance with opportunities for alpha generation.
Corporate America had a strong showing in the first quarter earnings season, posting 5% year-over-year EPS growth with wide participation in earnings surprises. Among the sectors, consumer discretionary, communication services and technology drove the biggest overall gains and most companies within the “Magnificent 7” continued to dominate. Notably, the first quarter should also mark a low point for the year, with every other quarter on track to deliver both sequential and annual growth. If this trend persists, all 11 S&P 500 sectors could see earnings grow on a year-over-year basis by the fourth quarter, a feat that has not been achieved since the second quarter of 2021. Much of this strength owes to success in defending margins (12.4% in 1Q24), with the combination of stronger-than-expected economic growth and easing labor pressures allowing corporates to retain pricing power.
Strong earnings have also helped fuel a return of buybacks. Whereas last year many companies slowed debt issuance amid an uncertain outlook for rates, this year issuance has rebounded, allowing for a renewed wave of buyback announcements. Some estimates suggest buybacks could reach $1 trillion for the year, a +13% annual gain, led by many of the mega-cap tech names. Many of these same companies are also investing heavily into AI. Consensus expects the five major AI “hyperscalers”1 to spend nearly $200 billion on capex this year (Exhibit 2), corresponding to +36% year-over-year and over 8x growth in the last decade, while S&P 500 capex more broadly accelerated at an estimated 9% year-over-year pace in the first quarter.
Solid growth and a renewed focus on shareholder return provide a further layer of support beneath the bull market, but at 20x forward P/E, the market isn’t cheap. Consensus earnings expectations for the year currently point to 11% growth, but our top-down earnings model suggests headwinds from a stronger U.S. dollar and slowing nominal growth could lead growth to undershoot those expectations. Profit margins have so far been resilient, but if growth were to slow more materially, firms’ pricing power would come under greater pressure. Finally, while the emphasis on AI may be justified, the concentration of returns amongst a few AI leaders suggests some vulnerability for markets as adoption speeds are still highly uncertain and sentiment has been ebullient.
Overall, despite recent strong equity performance, the end of monetary tightening combined with strong nominal GDP growth provide a constructive backdrop for U.S. equities over the remainder of the year. We continue to favor quality across asset classes, leading us to prefer large and mid caps over small caps, a balance of both value and growth and an emphasis on stock selection to identify the attractive companies with resilient profits, solid balance sheets and favorable relative valuations.