The recent focus on disinflationary trends in the U.S. economy has sparked debates among investors about its potential implications for stock market performance. Disinflation, defined as a slowdown in the rate of inflation or even a decline in prices, is often viewed as a double-edged sword for equities. On one hand, lower inflation can indicate a stabilizing economic environment, potentially supporting consumer spending and business investment. On the other hand, it raises concerns that reduced pricing power could limit corporate revenue growth and profitability, thereby dampening earnings expectations.
Addressing these concerns, strategists at BofA Global Research, Ohsung Kwon and Savita Subramanian, have analyzed the historical relationship between inflation trends and corporate earnings within the context of the S&P 500. Contrary to conventional fears, their findings suggest that disinflation may not necessarily pose a significant headwind to the financial health of American companies.
In a comprehensive client note, Kwon and Subramanian underscored that recent soft inflation data align with a potential “Goldilocks scenario” for the economy—where economic conditions are perceived as just right, not too hot to trigger inflationary pressures nor too cold to signal economic contraction. Despite worries that disinflation could undermine earnings growth due to the nominal nature of earnings, which typically benefit from higher inflation rates, the BofA strategists argue against this notion.
Their analysis pivots on the fundamental drivers of corporate earnings, emphasizing that demand dynamics and overall economic growth exert a more pronounced influence than pricing metrics alone. They assert that while a company’s revenue tends to correlate with indices like the consumer-price index (CPI) and producer-price index (PPI), these price metrics show no discernible correlation with the growth trajectory of corporate earnings. Instead, they highlight that real GDP growth demonstrates the strongest correlation with quarterly earnings growth of the S&P 500, outstripping other macroeconomic variables such as CPI, PPI, or nominal GDP.
Moreover, Kwon and Subramanian provide historical context, noting that inflation trends historically lag behind corporate earnings growth. For instance, movements in the CPI and PPI typically trail changes in corporate earnings by five quarters and three quarters, respectively. This lag underscores their argument that while inflation trends are relevant indicators of broader economic health, they do not directly dictate or significantly influence short-term corporate earnings outcomes.
Looking ahead, as the market anticipates a wave of earnings reports—particularly from technology sector stalwarts driving recent S&P 500 gains—the expectations are cautiously optimistic. While broader market earnings are forecasted to rebound for the first time since late 2022, there’s a notable deceleration projected for the tech giants. This divergence suggests a potential shift in market dynamics where sectors beyond technology could begin to exert greater influence on overall market performance.
BofA’s forward-looking outlook anticipates S&P 500 earnings to expand by 9% in the second quarter of 2024, aligning with historical averages but marking a modest slowdown compared to previous quarters. Amidst a backdrop of cooling economic growth, the scenario of decelerating GDP alongside accelerating EPS could present an ideal environment for U.S. equities. Historically, such conditions have coincided with benign interest rate environments and robust underlying fundamentals, which are typically supportive of equity market valuations.
In conclusion, while the specter of disinflation prompts valid concerns among investors, BofA’s analysis suggests that the resilience of corporate earnings against varying inflation dynamics underscores the importance of broader economic factors and earnings fundamentals in shaping market sentiment. As markets navigate evolving economic landscapes, including inflationary pressures, the ability of companies to adapt and thrive amidst changing economic conditions will likely play a pivotal role in determining the trajectory of stock market indices in the coming quarters.