Earnings season to test investor sentiment

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.

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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 actually 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.

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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 of 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 law-makers 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 the dot.com bubble years. The chart of the stock market then and now looks remarkably 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 actually 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 a more balanced approach as the red flags start to flutter in the summer breeze.

And finally….

Here in the UK, investors have other things to worry about than a market correction. With a new Prime Minister heading for a coronation this week, attention is quickly shifting once again to the Autumn Budget.

Speculation is mounting that an enlarged fiscal statement in October will also include a spending review that will set out the strategy and priorities until the next election, probably in three years’ time.

All those spending plans will have to be paid for, so the last few years’ concerns about tax hikes are certain to re-emerge in the weeks ahead. The bond market will be watching closely too. So far fixed income investors have broadly given Andy Burnham the benefit of the doubt. The summer break is likely to test that uneasy truce.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Direct shareholdings should generally form part of a well-diversified portfolio of other investments. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.