Tom Stevenson comments as earnings season provides an early summer test of the ongoing bull market and new Fed chair Kevin Warsh sets out his thinking about inflation, interest rates, and central bank reform to Congress.
Over the past couple of decades, markets have been tested over the summer lull. With sentiment increasingly fragile, this year looks like continuing that trend. And this week’s start to earnings season provides the first hurdle for investors to clear.
Bullish forecasts
In recent years, company profits have routinely come in ahead of expectations. That has kept the bull market on track for nearly four years now. Can 2026’s second quarter results round keep the pattern intact?
With earnings forecast to grow by 23% year on year, the bar has been set very high. Three months ago, profits were forecast to rise by 14% and did around twice as well. This time, the analysts have got in early, and it will be harder than ever for companies to surprise on the upside.
First off, as usual, will be the banks. With the big five – JP Morgan, Morgan Stanley, Goldman Sachs, Bank of America and Citigroup – forecast to deliver income growth of 27%, much of the good news is surely already in the price.
Growing list of concerns
The challenge for investors is even greater because the list of things to worry about is getting longer. Concerns include a rotation out of the tech stocks, which have driven markets higher. Investors are also worried about where the Federal Reserve goes next with interest rates in a more inflationary environment. Rising tensions in the Gulf add to the upward pressure on prices, via the cost of oil. And all those worries are showing up in the bond market, where yields are moving further into the ‘danger zone’ between 4.5% and 5%.
At that level, bonds provide a more compelling alternative to shares. And it becomes harder for investors to justify today’s highish valuations. Unsurprisingly, investors are looking to protect the gains they’ve already made, while remaining exposed to any future rises in the market.
Fed in focus
Top of the list of concerns is whether US interest rates go up from the current range of 3.5% to 3.75%. The markets are pricing in at least one quarter point hike this year. Against that backdrop, new chair Kevin Warsh will be answering questions from lawmakers in Congress this week.
Apart from his views on inflation and interest rates, they will be seeking to understand what his plans are to reform the workings of the Fed. He has already indicated that he thinks the central bank shares too much of its thinking. Less forward guidance could make it harder for the markets to gauge where interest rates are heading. And that could create more volatility around rate decisions.
How sustainable is the AI boom?
Rising interest rates are bad news for growth stocks. That makes questions about the sustainability of the AI investment boom more pertinent than ever.
The blistering performance of semi-conductor stocks, particularly in Taiwan and Korea makes global markets more correlated and vulnerable to a correction. Emerging markets are no longer such an obvious diversification from the US. More than $100bn has already been withdrawn from the Korean market this year as many investors have hit concentration limits in their portfolios and been forced to cash in profits to reduce exposure.
Competition from bonds
Adding to the list of reasons to be cautious is the rise in bond yields as investors worry about persistent inflation and rising interest rates.
The US Treasury 10-year bond now yields more than 4.5% and the UK equivalent is closer to 5%. That’s viewed as a kind of danger zone where bonds represent a more compelling alternative to shares and investors struggle to justify taking the extra risk inherent in the equity part of their portfolio.
Dot.com echoes
All of which evokes echoes of previous market cycles. The chart of the stock market then and now looks notably similar, and investors will be desperate to avoid a repeat of the 50% drawdown that devastated portfolios between 2000 and 2003.
A key difference between then and now is the support provided by corporate earnings. And that is why the results round that kicks off this week will be so closely watched.
The need for diversification
Fortunately, there are alternatives to the technology stocks that have lifted all boats in recent years. Over the past 18 months, European banks have performed as well as the S&P 500’s AI-related stocks. And the US benchmark’s equal-weighted version has continued to hit new highs even as the tech-dominated headline index has paused for breath.
Cautious investors are starting to embrace are more balanced approach as the red flags start to flutter in the summer breeze.
By Tom Stevenson, Investment Director, Fidelity International
