Earnings growth powers stocks higher

Bottom Line

Another day, another record high for US stock prices. To be sure, February and March were difficult months for equity investors, with the S&P 500 and the Nasdaq Composite down 10% and 13%, respectively, sandwiching the start of the US/Israeli invasion of Iran on February 28. Energy prices (West Texas Intermediate, or WTI) spiked more than 84% to nearly $120 per barrel by March 9, with the expectation that gas prices at the pump and nominal inflation would soon follow.

Since the end of March, however, investors have largely discounted the Iran conflict, even though the Trump administration’s expected four-to-six-week timeline has stretched out to 13 weeks and counting. Since the end of March, the S&P has rallied by more than 20% and is knocking on the door to 7,600 for the first time. Our price targets are 8,000 and 9,000 for year-end 2026 and 2027, respectively. The Nasdaq has done even better, surging more than 33% to new record highs.

Impact on inflation Lagging gas prices have risen 53% since the end of February to a peak of $4.56 per gallon last week, driving nominal CPI retail inflation from a five-year low of 2.4% year-over-year (y/y) in February to a three-year high of 3.8% in April. Bonds have been laser focused on this higher inflation resulting from the spike in energy prices. Benchmark 10-year Treasury yields have increased from 3.95% at the end of February to a peak of nearly 4.7% on May 19. 

All about earnings So, how is it that US equities are soaring in the wake of the Iran conflict, elevated inflation and rising bond yields? Look to the nearly completed first-quarter earnings season, which has been outstanding. Revenue for the S&P has risen 11.4% y/y in the first quarter, compared with FactSet expectations for a 9.8% increase. Earnings have soared 28.5% y/y, more than double the 12.6% consensus gain. Profit margins have exploded, increasing more than 17% y/y. Seven of the 11 S&P sectors experienced strong double-digit earnings gains, paced by 50% y/y increases in technology and communications services.

Economic roundtrip Citibank’s Economic Surprise Index reflects the vicissitudes of the Iran conflict. It peaked at 53.5 on February 2, plunged to 5.6 on April 20, then rebounded to 48 on May 21. We’re at 45 now. That is consistent with revised GDP growth of only 1.6% in the first quarter, potentially rising to the Atlanta Fed’s GDPNow tracking estimate of 3.8% growth in the second quarter. 

Solid US labor market Excluding an aberrant February, nonfarm payrolls have risen by an average of 153,000 jobs during January, March and April, and the unemployment rate is at a 10-month low of 4.3%. With initial weekly jobless claims for the May survey week at only 210,000, next Friday’s labor market update should be constructive.

Consumers still spending Buoyed by larger-than-usual tax refunds and record high stock prices, “Marpril” retail sales rose a solid 4.5% y/y during the Easter/Passover season. That compares with a strong 5.1% gain in 2025 and more modest gains of 3.0% in 2024 and 1.9% in 2023. We at Federated Hermes expect a softer May, however, as consumers attempt to repair their personal balance sheets and lift their savings rate up from a four-year low of 2.6% in April, ahead of summer vacations and the Back-to-School shopping season. 

Manufacturing solid The ISM manufacturing index has now been in expansion territory, rising above 52, in each of the past four months through April. Several of the regional Fed indices – particularly Empire, Chicago and Kansas City – have accelerated. Capital goods shipments nondefense ex-air have been strongly positive in seven of the past eight months.

Federal Reserve is likely on hold into the fourth quarter With the leadership transition of the Fed from Jerome Powell to Kevin Warsh now complete, any possible changes in interest rates are likely on hold until the last quarter of 2026 at the earliest. With the strong labor market, the Fed has no immediate need to cut rates. But with the rise in nominal inflation due to the spike in energy prices, the Fed will likely wait until developments in Iran improve and inflation recedes.

Outlook for growth improving The equity, fixed income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met last Wednesday to discuss the leadership and monetary policy transition at the Fed and the impact of the Middle East conflict on the US economy and financial markets.

First quarter 2026 GDP was revised down from a preliminary gain of 2.0% quarter-over-quarter (q/q) to a weaker-than-expected increase of only 1.6%. That compares to a fourth-quarter gain of 0.5% q/q and stronger third- and second-quarter gains of 4.4% (the best quarterly growth in two years) and 3.8%, respectively. A downward revision in inventory liquidation during the first quarter accounted for most of the delta. Importantly, the core private domestic final sales component rose a solid 2.4% in the first quarter. 

• The fiscal stimulus from President Trump’s One Big Beautiful Bill resulted in larger-than-normal tax refunds, and an early Passover and Easter helped to spark strong consumer spending in March and April. Despite the ongoing Iran conflict and spurring of inflation, the US labor market and manufacturing sector have surprised to the upside. First-quarter revenues and profits were outstanding. As a result, we raised our forecast for second quarter of 2026 GDP growth from 2.5% to 3.0%, while the Blue-Chip consensus raised its estimate from 1.6% to 1.7% (within a range of 0.5% to 2.8%). The Atlanta Fed’s GDPNow tracking estimate is at 3.8%.
• We expect the Iran conflict to be over by America250, which should lower energy prices and inflation, driving improved consumption, manufacturing, construction and employment trends over the summer months. So, we kept our forecast for third quarter of 2026 GDP growth elevated at 3.2%, while the Blue-Chip consensus reduced its estimate from 1.8% to 1.7% (within a range of 0.4% to 2.6%). 
• We similarly kept our forecast for fourth quarter of 2026 growth unchanged at 3.2%, while the Blue-Chip consensus trimmed its estimate from 2.0% to 1.9% (within a range of 0.9% to 2.7%).
• But because of the first quarter’s downward revision, we trimmed our estimate for full-year 2026 growth from 2.6% to 2.5%, while the Blue Chip consensus reduced its estimate from 2.2% to 2.0% (within a range of 1.5% to 2.4%). 
• Because of the temporary spike in energy prices and the potential for sharply higher nominal inflation to bleed into elevated levels of core inflation over time, we raised our year-end 2026 estimate for core CPI inflation from 2.7% to 2.9% (compared with core CPI of 2.8% y/y in April 2026), while the Blue Chip consensus hiked its forecast from 3.2% to 3.4% (within a range of 3.1% to 3.8%). We also raised our year-end 2026 estimate for core PCE inflation from 2.8% to 3.0% (compared with core PCE of 3.3% y/y in April 2026), while the Blue Chip raised its estimate from 3.3% to 3.4% (within a range of 3.2% to 3.7%).
• Buoyed by our optimism for a post-Iran-war rebound in economic activity in the second half of 2026 and next year, we kept our full-year 2027 GDP growth unchanged at an elevated 3.0%, while the Blue-Chip consensus kept its estimate unchanged at 2.0% (within a range of 1.4% to 2.4%).
• We left our year-end 2027 estimate for core CPI unchanged at 2.4%, while the Blue-Chip consensus raised its estimate from 2.4% to 2.5% (within a range of 2.1% to 3.1%). We raised our year-end 2027 estimate for core PCE from 2.4% to 2.5%, while the Blue-Chip consensus also raised its estimate from 2.4% to 2.5% (within a range of 2.1% to 3.0%). 

Read more about our views and positioning at Capital Markets.

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