Investors rarely think of Federal Reserve tightening as a good thing. But the reasons the Fed tightens can be great for corporate earnings.
When Fed policy makers last week indicated they expected to start raising rates in 2023—earlier than they had earlier projected—markets had a bit of a fit. What had become of the Fed’s plan to look through transitory inflation, or its bid to see just how low unemployment could go?
There is a continuing debate in some corners of the market over whether the Fed made a communication error or, worse, that the Fed is going back on its promise to seek inflation that exceeds its 2% target following periods when inflation falls short of that mark. But what really changed might have been that the Covid-19 crisis has faded quicker than the Fed worried it might, and the economy is looking stronger as a result.
The median forecast among Fed policy makers now calls for gross domestic product to increase by 7% from a year earlier in the fourth quarter, which compares with a forecast of 6.5% published following the Fed’s March meeting. Private forecasters have stepped up their GDP estimates by even more, from 6.3% in mid-March to 7.7% last week, according to an IHS Markit survey.
Those upgrades have been driven by gains the economy has made in the first half of the year—first-quarter GDP was significantly stronger than economists thought it would be back in March, and they have been steadily increasing their second-quarter GDP forecasts.
When it comes to corporate earnings, analysts have been pushing up their own estimates too, but perhaps not by enough. Companies start reporting second-quarter earnings in mid-July, and analysts are now looking for earnings per share at companies in the S&P 500 to increase by 64% versus a year earlier, according to Refinitiv, which compares with a forecast of 54% at the beginning of the quarter. The comparison is with the worst period of the crisis last year, of course, but earnings are also expected to be about 8% above their second-quarter 2019 level.
Analysts’ earnings estimates at the end of any given quarter are usually short of how earnings actually come in, but given how boomy the economy has been, those estimates might be unusually low. What happened in the first quarter may be instructive: At its outset, analysts thought S&P 500 earnings would grow by 16%, and actual growth was 58%.
Maybe investors have absorbed this, and the likelihood that earnings will be significantly better than analysts expect has already been cooked into markets. But if they were surprised by the Fed’s change of tone last week, they may be about to get a more pleasant surprise.
Write to Justin Lahart at justin.lahart@wsj.com
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