Morgan Stanley Warns: High Rates Dim S&P 500 Earnings Glow

Key Takeaway

• Higher Treasury yields are dampening the impact of strong corporate earnings, with S&P 500 firms' share prices showing muted reactions despite 81% beating profit estimates.
• Morgan Stanley's Wilson warns of a potential 7%-11% downside in price-to-earnings ratios due to persistent high rates, despite a recent rally on rate cut hopes.
• Goldman Sachs highlights that rising bond yields, reflecting fears of persistent inflation, constrain equity valuations and challenge stock performance.

Earnings Resilience Amid Rising Rates

Despite the backdrop of higher Treasury yields, first-quarter earnings have showcased remarkable resilience, with a significant portion of S&P 500 companies not only meeting but exceeding analysts' profit expectations. According to Bloomberg Intelligence, 81% of S&P 500 firms have surpassed first-quarter profit estimates, highlighting the strength of Corporate America in a challenging economic environment. However, Morgan Stanley's Michael Wilson notes that the positive earnings season has been overshadowed by the pressure of higher rates on valuations, leading to muted reactions in share prices despite strong profit beats.

Consumer Strength Supports Corporate Profits

The underlying strength of the consumer has been a critical factor in supporting corporate earnings. Visa’s CFO, Christopher Suh, and American Express’ CEO, Stephen Squeri, both emphasized the stability of consumer spending across various segments, indicating no significant shifts in consumer behavior. This resilience is further evidenced by companies across different sectors, such as Merck, Ford, Chipotle, Waste Management, and Royal Caribbean, affirming or raising their 2024 earnings guidance. The sustained consumer spending, coupled with high net profit margins—currently around 11.5% and expected to exceed 12% for the rest of the year—paints a picture of a robust economic foundation driving corporate profitability.

Market Adjustments to Interest Rate Pressures

The S&P 500's reaction to the earnings season reflects the broader market's sensitivity to interest rate movements. Despite strong earnings, the index has seen a contraction in its price-to-earnings (P/E) ratio, moving from 21.6 at its peak to 20.8. This adjustment is a direct response to the dampening effect of higher rates on investor appetite for future earnings. Michael Wilson of Morgan Stanley predicts a potential downside in P/E ratios of about 7% if rates stay at current levels, with a more significant downside if the 10-year Treasury yield rises linearly to 5% by mid-July. This scenario underscores the market's vigilance towards inflation and interest rate trends, with historical instances showing significant market reactions to sharp yield increases.

Sector-Specific Dynamics and Forward Outlook

The earnings landscape reveals a nuanced picture, with energy companies benefiting from higher oil prices and contributing significantly to the positive adjustment in S&P 500 earnings estimates for the second quarter. However, sectors like industrials and consumer discretionary face challenges, with downward revisions in earnings estimates for key players like Boeing and Tesla. Despite these sector-specific headwinds, the broader market outlook remains optimistic, supported by a strong jobs market and resilient consumer spending. Corporate commentary reinforces the expectation of sustained economic strength without the immediate threat of a recession, suggesting a continued supportive environment for corporate earnings.

Street Views

• Michael Wilson, Morgan Stanley (Neutral on Corporate America):

  "We think this is attributable to the pressure on valuations from higher rates, a condition that could remain with us in the near-term unless the Federal Reserve signaled a dovish tilt in its policy meeting this week."

• David Kostin, Goldman Sachs Group Inc. (Neutral on S&P 500):

  "The dictum ‘earnings drive stocks’ is particularly apt in the current environment where equity valuations are constrained by rising bond yields that reflect investor fears of persistent inflation... Stocks can digest a growth-driven rise in rates but struggle from hawkish monetary policy or when yields rise sharply."