Strong corporate earnings are helping support markets, but persistent inflation and a less predictable Federal Reserve continue to complicate the outlook. Allworth Chief Investment Officer Andy Stout explains what these crosscurrents could mean for investors.
Broad earnings growth, an energy problem that cuts in many ways, and a Fed that has stopped explaining itself are all playing out at once. How they’re connected is perhaps more important than any one of them on its own. Let’s begin with earnings, as that strength has offset some of the concerns weighing on investors.
Earnings Growth Is Wide-Ranging (Not Just the Magnificent 7)
Profits for the S&P 500 are running 32% higher over the past year, well above the 23% Wall Street expected at the start of earnings season. Fueling this growth is a remarkable 85% of companies beating estimates, the highest rate in five years. Beneath the headline, the details are just as impressive.
Growth is coming in at 31% if we strip out the Magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla). Remove the broader AI complex of companies, and earnings are 24% higher. Small caps are keeping pace too, with the Russell 2000 posting 11% growth, its first double-digit showing since 2022.
Energy is leading the way among all S&P 500 sectors, with its earnings up 150%. Fueling this surge is the spike in oil prices. That matters because it’s one of the main reasons inflation hasn’t cooperated, which we’ll tackle shortly.
The only sector showing a decline in profits is health care, but that's mostly an accounting quirk related to mergers. If those acquisition-related charges are excluded, the sector’s growth is closer to 20%.
The Economy Behind Those Profits
Earnings like these don't come from nowhere; they’re driven by a strong economy. While the second-quarter GDP print appeared underwhelming at 1.5%, the details were much better. Consumer spending grew 3.2%, a significant improvement from the 0.5% first-quarter pace. This pickup in spending contributed 2.1 percentage points to the final GDP number.
The other primary contributor was business spending ex-inventories, adding 1.2 percentage points to GDP. This business investment tells the AI side of the story. Hyperscaler spending (e.g., AI data center buildouts) by major tech companies is on pace to reach nearly $790 billion this year, a 90% increase over 2025. A large portion of that spending shows up as revenue for chipmakers and equipment suppliers, a major factor behind tech’s 70% earnings growth.
As the above chart shows, consumer spending and business spending ex-inventories lifted the economy in the second quarter, while inventories and trade (i.e., net exports) subtracted from growth. Strip out those more volatile components, along with government spending, and the picture becomes much stronger. Real final sales to private domestic purchasers grew 3.9%, the best pace since early 2023. That is a better measure of underlying domestic demand and suggests the economy entered the second half with more momentum than the 1.5% headline GDP number implies.
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One Oil Price, Two Very Different Effects
The same energy dynamic driving earnings has been cutting the other way on inflation. Fortunately, the latest inflation data has cooled alongside oil prices retreating.
Oil and gas prices are off their peak levels from April and May, and as a result, the monthly inflation readings have steadily moved lower. In July, headline consumer inflation (CPI) rose just 0.1%, pulling the year-over-year rate down to 3.4% from 3.5%. Core CPI, which removes volatile food and energy, matched its five-year low of 2.5%, last touched in February.
Underneath those headlines, price pressure actually broadened. The portion of core CPI categories running above 2% (annualized) in July rose to 53% from a 42% average in the second quarter.
Energy prices have recently started to move higher after initially dipping in early August. This has led to inflation nowcasting estimates showing headline prices at an elevated 0.35% and core at 0.2% (as of 8/13).
Another inflation metric we closely watch is producer prices (PPI), which also showed some improvement in June and July. Headline PPI was flat in July, and core PPI rose just 0.2%, both below expectations for a second straight month, as transportation costs fell 1.8% alongside retreating oil prices.
The headline data is generally trending in the right direction. However, the details show that the inflation problem is far from solved, especially with gas prices still about 30% higher than pre-war levels.
The Fed targets a 2% PCE inflation rate (PCE is broader than CPI), and based on July’s CPI and PPI readings, headline PCE could come in around 0.15%, and core could hit 0.25%. If that happens, the 12-month change would be roughly 3.7% for headline PCE and 3.3% for core PCE, well above the Fed’s 2% target.
A Fed That Has Stopped Explaining Itself (And a Surprising Twist)
This inflation environment means the Fed has less room to maneuver. On July 29, the Fed held rates at 3.5-3.75%. It was not a unanimous decision, as three policymakers dissented in favor of a quarter-point rate hike to fight inflation. In his post-meeting press conference, Fed Chair Kevin Warsh vowed to restore inflation to 2% but offered no clear plan for how the Fed will achieve it.
In fact, under Warsh’s regime, which just started in May, the Fed has significantly reduced its forward guidance. For example, at his first meeting in June, Warsh pulled his own interest rate projection and shortened the Fed’s official meeting statement to 130 words from 341. Moreover, he’s recently floated the idea of the Fed meeting only six times a year instead of the eight the committee has held over the past 45 years.
This reduced communication and lack of a shared roadmap have led the bond market to lose confidence in the Fed’s ability to reduce inflation to its 2% target, as shown by the 30-year Treasury yield reaching its highest level since 2007.
There is a twist here. Warsh may actually welcome this reaction. He believes the Fed’s prior communication policy resulted in market prices that mirrored Fed guidance rather than economic reality. Warsh has said market prices are one of the most important sources of information for policymakers, and he prefers that prices reflect data, not what the Fed has already said.
The rise in long-term rates following the Fed’s July meeting is not a policy failure in Warsh’s view. It’s the market doing exactly what he wants it to do, suggesting investors aren’t convinced the Fed will bring down inflation without action.
That in itself will not force the Fed’s hand. The committee will take into consideration a significant amount of data when setting policy, including July’s somewhat weak labor market report, recent inflation updates showing deceleration, and higher energy prices, to name a few.
These developments have shifted expectations for the Fed. A few weeks ago, there was a 60 to 70% chance of a hike on September 16, but that has fallen to below 30%. That doesn't mean the market thinks inflation is under control. After all, the yield on the 30-year Treasury remains elevated.
Putting the Puzzle Pieces Together
Corporate America is posting record profits, and the economy is on mostly stable footing. However, the labor market is showing weakness, and energy continues to pressure inflation, putting the Fed in a precarious position. At the same time, the central bank has pulled back on forward guidance, creating a level of monetary policy uncertainty the market hasn’t faced in decades.
This calls for a portfolio built to handle an evolving and complex economic backdrop while also incorporating your financial planning and investment needs. That means helping to manage market volatility, addressing concentrated stock concerns, and investing with an eye toward taxes, so your plan holds up regardless of how this backdrop resolves.