Raising our estimates on the other side of the wall

The market’s latest bug-a-boo is inflation: the war has gone on too long, the narrative goes, so higher gasoline prices are beginning to bleed into higher nominal, and core, inflation readings. This is certainly the case at the margin, and even we have pushed out the start of the Warsh Fed rate-cutting cycle from June to probably December. But with wages still relatively controlled, especially relative to sterling productivity gains, we continue to see the oil shock as a one-off that inevitably will end. More importantly, a little extra inflation, when accompanied by a patient Fed and strong earnings growth, has little impact on stock returns. Rather, as we’ve long highlighted, stocks live on nominal earnings growth, and the recent earnings season has left us, and most of Wall Street, raising our out-year earnings numbers yet again. So with this further-improved earnings outlook, we are raising our S&P 500 targets, for this year and next, to 8,000 and 9,000, respectively.

Key points:

1. Bonds get hit when inflation rises, but not always stocks. Particularly when the central bank is perceived as dovish, bonds worry that higher inflation will persist. So last week’s unexpectedly high producer price index and consumer price index prints (core CPI came in at 2.8% versus 2.7% expected) hit US Treasury bonds hard, with the yield on the 10-year rising by 24 basis points. Note that even in Europe, where growth is slower and the European Central Bank is nonetheless hinting at a hawkish rate hike, the German Bund yield also rose 15 bps. For stocks, however, the picture is more nuanced. Though stocks were down hard on Friday, for the week they were roughly flat. Historically, stocks have served as an inflation hedge, demonstrating the ability to post strong returns relative to bonds in higher inflationary environments, so long as earnings growth remains strong.
2. Particularly given a dovish Fed, the odds of a significant demand pullback due to the current setup seem low. Two important offsets are muting the impact on the consumer: the One Big Beautiful Bill (OBBB) tax cuts and the wealth effect of the market rally. In addition to lower tax withholding rates, the OBBB has also led to tax returns that are, on average, 18% larger than last year. With the benefits of the bill accruing primarily to low- and middle-income consumers, this should provide a buffer from higher gas prices, with the increase in tax returns offsetting six to eight months of $4.50 gasoline, and for higher-income consumers, the positive wealth effect from higher equity prices has helped to bolster spending. Both sides of the “K” are covered, at least for now. For stocks, this is important. Despite the inflation fears, nominal economic growth should remain high.
3. Stocks can pass through and/or manage inflation, especially when productivity is booming due to AI. Earnings beats this season were actually very broad, with all sectors beating consensus, and 82% of stocks beating. Earnings growth y/y was double digit in eight of 11 sectors. Productivity gains over the last four quarters have been 3% vs the longer-term average of 2%, and the pace of margin expansion is now at levels only seen during the peak of the dot-com boom. Historically, stocks do about equally well in low and high inflation environments, as long as earnings growth is strong.
4. Another welcome development last week was a pivot in the US-China relationship from “Cold War”-like to something closer to a normalization. China gave President Trump a warm welcome, and we expect further positive details to emerge as we approach the upcoming September 24 summit: while rare earths and semiconductors remain strategic choke points for both nations, we expect to see the rollback of tariffs on less-strategic goods (e.g. “toys”), as well as increased Chinese imports of US energy and agricultural and aerospace products. The US-China Board of Trade was another step towards both sides developing a more constructive relationship. 
5. Following earnings season, we are raising our earnings forecasts for this year through 2028, basically predicated on a continuation of the accelerated margin expansion that we’ve seen in recent quarters alongside strong nominal GDP growth. We are now at $450 in 2028 (previously $410), implying an S&P 500 target for 2027 of 9,000 (previously 8,200). Note that 9,000 utilizes a relatively conservative 20x multiple, which we may reevaluate (higher) should the quarters ahead continue to surprise to the upside. For 2027, we are raising our earnings number on the S&P to $390, implying a year-end 2026 market level of about 8,000. 
6. Eventually, we anticipate inflation will subside given the Goldilocks labor market and little sign that higher oil is translating to higher wages. Both sides of the Iran conflict need the war to end, as does the rest of the world. So, inevitably, it will end. When that happens, the y/y inflation prints will face easy comparisons which will provide a favorable disinflationary tailwind. With this, the Warsh Fed, already inclined to cut rates to help the rate-sensitive parts of the economy that are suffering, will likely begin a new rate-cutting cycle. That will be more good news for stocks ahead.

One last point: For all the talk of market narrowness, the market has actually broadened out year-to-date, not narrowed, and that trend is likely to continue. Although the AI-related stocks, for sure, have led the market in percentage terms off its lows, that’s partly because the AI stocks got hit hardest earlier in the year. On a year-to-date basis, the “broadening-out trade” that we’ve been anticipating is actually happening. Small caps, value indices, and the emerging markets have all generated double digit returns year to date, and have all outperformed the Magnificent Seven. We expect these trends to continue as fear around the Iran conflict and inflation fades, the Fed resumes cuts, and economic growth re-accelerates. This kind of leadership rotation is a common feature of sustainable bull market runs. We are maintaining our overall equity overweight/bond underweight in our balanced models, with that overweight balanced among US value, US growth, small caps, and emerging markets. The only area we are underweight, besides bonds, is developed markets equities, where the growth story is less compelling and stagflation concerns are more realistic.