The recent cooling of inflation data has sent mixed signals to investors. While many cheered the potential end of a period of high prices, some worried it could dampen corporate earnings growth. However, BofA Global Research strategists believe the opposite might be true – disinflation coupled with accelerating earnings could be the ideal recipe for a thriving stock market.
This article explores BofA’s analysis and delves into the potential implications for investors.
Is Disinflation a Threat to Earnings?
A common concern is that disinflation, a decrease in the rate of inflation, could erode companies’ pricing power and ultimately hurt their bottom line. After all, companies can boost profits by raising prices alongside inflation. However, BofA argues that historical data doesn’t support this fear.
According to Ohsung Kwon and Savita Subramanian, BofA equity and quant strategists, there’s “no statistically significant relationship” between pricing (as measured by the Consumer Price Index (CPI) and Producer Price Index (PPI)) and earnings growth. They found a much stronger correlation between real Gross Domestic Product (GDP) growth and earnings growth for companies in the S&P 500.
Furthermore, inflation often lags behind changes in earnings. The BofA strategists point out that the correlation between S&P 500 earnings and inflation is lagged by the CPI and PPI by five and three quarters, respectively. This suggests that even if disinflation does occur, it wouldn’t necessarily translate into immediate negative impacts on earnings.
Earnings Growth on the Horizon
The BofA report comes as the U.S. stock market faces a crucial test with the upcoming earnings season. While the “Magnificent Seven” tech giants have been leading the charge so far, the broader market is also expected to show positive signs.
Kwon and Subramanian predict that for the first time since the fourth quarter of 2022, over 90% of S&P 500 companies (excluding the tech giants) are likely to report year-over-year quarterly earnings growth. This indicates a potential broadening of the market rally beyond the tech sector.
Interestingly, the earnings growth for the tech giants themselves is expected to slow down for the second consecutive quarter. This could lead to a shift in investor focus, potentially benefiting other sectors with stronger earnings momentum.
A Golden Opportunity: Disinflation and Economic Growth
The BofA strategists believe the combination of disinflation and accelerating earnings growth could be an exceptional environment for the stock market. Historically, periods with slowing GDP and rising earnings per share (EPS) have coincided with benign interest rates and strong market fundamentals.
This scenario could unfold because a cooling economy might prompt the Federal Reserve to maintain a dovish monetary policy, keeping interest rates low and providing a tailwind for stock prices. Additionally, companies with increasing profits would become even more attractive to investors.
Market Outlook: A Brighter Future?
The recent market performance seems to align with BofA’s analysis. U.S. stocks closed higher on the day the report was released, with the Dow Jones Industrial Average reaching a record high. This could be a sign of investor optimism about the potential for continued growth despite disinflationary pressures.
Key Takeaways
- Disinflation may not be a significant threat to corporate earnings as previously thought.
- Real GDP growth appears to have a stronger correlation with earnings growth compared to inflation.
- The upcoming earnings season could see broader market participation beyond the tech sector.
- A combination of disinflation and accelerating earnings growth could be a positive catalyst for the stock market.
Conclusion
BofA’s analysis offers a compelling perspective on the potential impact of disinflation on the stock market. While the coming months will be crucial in confirming these predictions, the prospect of disinflation coinciding with strong earnings growth is a scenario worth considering for investors seeking opportunities in the current market environment.
