A third consecutive upside inflation surprise and a spike in geopolitical tensions in the Middle East last week took some air out of the recent equity rally. Market participants continued to push the potential for rate cuts down the road as robust economic momentum puts upward pressure on prices and mounting supply chain risks could further stoke inflation. For the week, the S&P 500 fell 1.5% while the Dow Jones and Nasdaq Composite shed 2.4% and 1.6% respectively. Stocks had shrugged off much of the year-to-date backup in interest rates with the expectation that economic strength would drive upside in corporate profits; however, equity investors are starting to take notice as the U.S. 10-year Treasury yield crossed above 4.50% last week (and is now pushing over 4.60% in this week’s early trading) after starting the year at just 3.88%.

The growing trend of hotter than expected inflation readings is making it more difficult for the Federal Reserve to justify beginning to ease its policy rate lower. March’s consumer price index (CPI) report showed headline price growth accelerating to 3.5% year-over-year from 3.2% in February (compared to the consensus economist forecast of 3.4%). Core inflation (excluding food and energy) also came in hotter than expected holding steady at 3.8% year-over-year. The March producer price index (PPI) did ease inflation concerns a bit when it was released on Thursday as it came more in-line with expectations at just 2.1% year-over-year (or 2.4% excluding food and energy).

Following the inflation report, market participants have now priced in expectations for just one or two rate cuts in 2024, most likely beginning in September, and futures markets reflect a 16% probability of no rate cuts this year, according to the CME FedWatch Tool. For reference, at the start of the year market participants expected as many as seven rate cuts in 2024 with almost no probability assigned to the potential for no rate cuts. Growing odds of higher for longer interest rates withdraws one of the key supports for elevated equity market valuations.

The other key factor that has underpinned rising valuations is the anticipation that corporate earnings will accelerate meaningfully this year from last year’s modest growth. According to FactSet, S&P 500 earnings are expected to grow over 10% this year, followed by growth of 14% then 13% in 2025 and 2026 based on aggregate consensus analyst forecasts for all of the index members. While last year’s paltry earnings growth of less than 2% sets a relatively low bar, there have only been two occasions since 1980 when corporate earnings have logged three consecutive years of double-digit growth when they aren’t recovering from recession, per the Wall Street Journal’s James Mackintosh.

As a result, anticipation is high for the first quarter corporate earnings season that kicked off with reports from several large financial institutions last week as investors try to gauge the initial read on 2024’s potential. The season got off to a bit of a tepid start as big banks gave disappointing guidance on net interest income under the pressure from higher for longer rates, but they also highlighted that consumers and businesses are exhibiting sustained strength. They dialed back loan loss reserves in response to healthy credit conditions. Earnings reports will start to ramp up this week with 42 S&P 500 members on the docket to announce results.

Investors will also be keeping an eye on the conflict in the Middle East as Israel weathered a retaliatory strike by Iran over the weekend in response to an attack against the Iranian consulate in Damascus that was attributed to Israel. Iran officials have stated that the matter is concluded, sparking hopes for a de-escalation in tensions. However, Israeli officials have stated that Israel has no choice but to respond with force to the Iranian attacks, which has put markets on the defensive in this week’s early trading.