AI-Driven US Stock Rally Faces Earnings Test: Analysts Weigh In

The second-quarter reporting season is underway, and analysts are closely monitoring the AI-driven rally in U.S. stocks. Buoyed by optimism surrounding artificial intelligence and the resilience of the U.S. economy, the stock market has experienced significant growth this year. However, experts exercise caution as they assess the impact of earnings on the sustainability of these gains.

Profit Expectations and Market Performance

According to Refinitiv data, strategists anticipate a 6.4% decline in profit for S&P 500 companies compared to the second quarter of the previous year. Despite these subdued estimates, several analysts believe that companies will outperform expectations. However, they also acknowledge that surpassing estimates might not be sufficient to maintain the upward trajectory of equities witnessed in 2023 thus far.

The Nasdaq, known for its heavy concentration of technology companies, has enjoyed a remarkable surge of 33% this year, outperforming the broader S&P 500, which has recorded a 16% advance.

Insights from Financial Institutions

Morgan Stanley: The primary driver behind the stock market rally this year has been the expansion of price-to-earnings ratios, indicating that investors are largely unconcerned about short-term earnings pressure. Nevertheless, Morgan Stanley's strategists caution that delivering "better-than-feared" earnings for Q2 will not be sufficient, considering the increased valuation of stocks. They assert that companies must raise profit forecasts to support their current valuations, which face challenges from diminishing liquidity.

Goldman Sachs: While companies are expected to surpass the modest expectations set for the second quarter, Goldman Sachs expresses reservations about consensus earnings estimates for 2024. They voice concerns about the ability of firms to sustain profit margins amidst cooling inflation. Furthermore, Goldman Sachs emphasizes the significance of AI-related earnings and guidance from influential companies like Nvidia, as they help identify potential long-term beneficiaries.

BlackRock: Laura Cooper, senior macro strategist for iShares EMEA at BlackRock, observes that better-than-expected earnings have not been the main catalyst driving returns this year, given the AI-fueled rally. Cooper cautions against a broad re-allocation to risk assets, highlighting that only specific sectors, such as energy and healthcare, have factored in the effects of economic damage into their estimates.

Deutsche Bank: The extent of the market rally during the reporting season is influenced by the positioning of equities leading up to it. Given the substantial gains in stocks since the first quarter and an "overweight" equity positioning, Deutsche Bank expects a relatively muted market reaction to Q2 earnings. Nevertheless, they acknowledge the possibility that this season could contribute to further equity growth. Deutsche Bank's strategists anticipate a second consecutive quarter of sequential earnings growth, potentially altering the prevailing expectation of an impending earnings recession.

Wells Fargo: Investors may be underestimating the impact of sustained higher interest rates on earnings. Scott Wren, senior global market strategist at Wells Fargo Investment Institute, believes that the Federal Reserve will continue to raise interest rates, resulting in lower earnings for S&P 500 companies this year compared to 2022. He further suggests that the economy may slip into a recession.

BofA: Earnings pressure is expected to bottom out in Q2, with most sectors projected to stabilize their margins going forward. The brokerage firm anticipates companies highlighting improved business conditions following a trough in the March-April period. BofA's analysis is optimistic about economically sensitive sectors, forecasting a rally in cyclical stocks during the latter half of the year.

Citigroup: While positive surprises are likely, particularly from the technology and industrial sectors, caution prevails among investors who are eager to punish stocks that fail to exceed expectations. Consequently, highly crowded stocks, including major AI players, face the greatest risk during this earnings season, as identified by Citigroup.

In summary, analysts approach the ongoing earnings season with measured optimism amidst the AI-driven U.S. stock rally. While profit expectations remain modest, there is hope that companies will outperform estimates. However, sustaining the market's upward trajectory requires companies to raise profit forecasts and support their valuations. With various financial institutions offering insights, it is clear that the performance of AI-linked stocks and the broader market will be closely watched as investors seek long-term beneficiaries and evaluate the impact of earnings on stock prices.