U.S. stocks remained under pressure last week amid a busy week of earnings reports and continued investor focus on the backup in interest rates and the conflict in the Middle East. The S&P 500 dipped into correction territory following last week’s 2.5% loss that brought the index down 10% off its highs from the end of July. The Dow Jones also lost 2.1%, which pulled its year-to-date return into negative territory. Meanwhile, the Nasdaq Composite tumbled 2.6% and also fell into correction territory but is still up over 21% on the year given its concentrated exposure to large cap technology stocks that have accounted for the majority of U.S. equity market gains this year.

With third quarter earnings results in the books for half of the members of S&P 500, reported earnings have outpaced expectations and have put the index on track for positive year-over-year earnings growth after three consecutive quarters of negative growth. According to FactSet, with 78% of reporters beating earnings forecasts so far, the S&P 500 is tracking towards earnings growth of 2.4% compared to a year ago after falling 4.2% year-over-year last quarter. However, the market response has not been favorable in general. Companies that have missed earnings expectations have been punished with an average stock price reaction of -5.2%, while companies that beat expectations have only fared a little better with an average stock price reaction of -1%.

There are several factors driving the negative market reactions despite healthy headline earnings growth. The surge in long-term interest rates is certainly front and center as a headwind that has taken some of the air out of extended U.S. equity valuations. Furthermore, earnings this year have received a lot of support from price increases and cost cutting measures as opposed to real, volume-driven sales growth, which is generally viewed as a more sustainable component of growth. Bank of America pointed out in a recent research note that real sales growth in the third quarter for the S&P 500 is actually down at -2.5% year-over-year compared to headline nominal growth of about +2%. With that context, the consensus analyst forecasts for S&P 500 earnings growth of 12% in both 2024 and 2025 are increasingly coming under investor scrutiny. The flow of corporate earnings reports will remain strong in the week ahead with another third of S&P 500 companies on the docket to report results.

In addition to earnings, investors are also assessing some important incoming economic data, including last week’s third quarter GDP report which showed that U.S. economic output grew at an incredible 4.9% annualized rate on a seasonally- and inflation-adjusted basis. That growth rate is double the second quarter pace and handily beat the economist consensus forecast of 3.8%. The strength was broad based with consumption up 4.0%, government spending up 4.6%, and residential investment up 3.9%, though this component will likely slow as mortgage rates pushed as high as 8% this month.

The continued strength in the economic data puts pressure on the Federal Reserve in the fight to rein in inflation in the face of generous fiscal stimulus and a robust labor market. The central bank will meet this week and present a monetary policy update on Wednesday. It is widely expected that they will abstain from a rate hike at this meeting as they gauge the impact of the sharp recent rise in long-term rates and the impact that has on the economy. However, more reports like the third quarter GDP report could keep more rate hikes on the table at future meetings. This Friday’s October jobs report will be an important indicator about the potential for future rate hikes. As such, we may continue to see the trend where good economic news is bad news for financial markets and vice versa as it determines how hard the central bank needs to push the policy brakes.