The first quarter earnings season will kick into high gear next week, with major US banks, as always, setting the tone. However, this time investors could pay even more attention to those results as the turmoil in the banking sector was responsible for a massive downshift in interest rate expectations. In general, earnings are set to contract for a second consecutive quarter, while valuations remain elevated and a recession is just around the corner.

Equity markets defy earnings downgrades

Major US indices finished a rather turbulent first quarter on a solid note despite the unexpected failures within the financial sector, which lead to a vast selloff in banking stocks and increased uncertainty regarding the resiliency of the US economy. Following this crisis, corporate financial estimates got revised significantly lower to adjust to the worsening macro environment, but stock prices followed a different route.

As the tech-heavy Nasdaq 100 climbed more than 20%, while even the ‘defensive’ Dow Jones index managed to post a borderline quarterly gain, it is obvious that the ‘bad news is good news’ trend still holds for equities. To be clear, the latest moves in stock markets seem to be solely driven by expectations of faster rate cuts by the Fed, completely ignoring the constantly deteriorating macroeconomic backdrop. Historically, a recovery has never started before a recession struck, threatening the sustainability of the latest rally we are seeing in stocks.

 Will the Fed blink this time?

Undoubtedly, the implications of remarkably high interest rates in the economy have started to become evident with the turmoil in the banking sector and it is difficult to predict what comes next. At the same time, most leading indicators are pointing to a recession and inflation has been coming down swiftly, so why does the Fed seem reluctant to loosen its monetary policy?

It is very simple; inflation remains the number one threat and the Fed has repeatedly stressed that it is willing to absorb collateral damage to restore price stability. Admittedly, the Fed’s liquidity injections to support banks merely unwound its quantitative tightening, allowing risky assets to rally and inflation fears to resurface. Moreover, although the jobs market exhibited some signs of weakness lately, it remains relatively tight, while OPEC’s surprise production cut decision last week emerged as an unexpected upside risk for inflation.

Factoring in all the above, it seems that investors are currently missing a piece of the puzzle. Stocks are trading at levels that reflect the scenario of a Fed pivot, a soft landing and no further negative earnings revisions, but can this really materialize without inflation shooting up? In a nutshell, it’s probably too early for the Fed to blink and we should see a significant downside correction in risky asset prices coupled with concrete evidence that inflation is under control before that happens.

Inflated valuations open the door for more downside

After a prolonged period of slowing economic activity, two consecutive negative earnings prints for the US stock indices are pretty much anticipated as many firms have already warned of compressed margins and softening consumer demand in previous earnings calls. What’s concerning, though, is that valuations are inconsistent with the current macroeconomic conditions, failing to reflect existing downside risks.

And that’s before considering that earnings estimates could be revised significantly lower during the course of the year in the case that a severe recession strikes or a renewed inflationary wave depletes profit margins. Don’t forget that bonds have been brought back to life for the first time since the 2008 crisis, making the risk/reward relation for US equities even less attractive in those turbulent times.

Therefore, this earnings period is likely to severely punish those who miss expectations, whereas for relative winners the upside seems limited. For the rest of the year, companies will also continue to have limited access to capital and high borrowing costs, making it very difficult for them to improve their growth prospects.

Will the US 500 revisit its lows?

Taking a technical look, the US 500 index has respected the Fibonacci levels taken from its 2,191-4,816 uptrend, which extended from the pandemic lows till the all-time high. Moreover, in 2023, the price has jumped above the restrictive trendline drawn from previous highs and is currently trading above the 4,000 psychological mark, suggesting a bullish technical outlook.

Hence, the upcoming earnings parade could determine whether the index will extend this outperformance or retrace lower to reflect growing downside fears. In the negative scenario, further declines could cease at the 38.2% Fibo of 3,814. On the other hand, should earnings surprise to the upside, the bulls could aim for the 23.6% Fibo of 4,198, which acted as strong resistance in 2023.