New targets for S&P 500, earnings forecasts, rate hikes and AI

Further upside for the S&P 500 index has been forecast after a leading bank said the start of US interest rate hikes did not automatically mean a more challenging period for stocks.

While volatility can increase around the beginning of a tightening cycle, UBS Global Wealth Management said US equities have historically been resilient after the first hike.

In its note published today, UBS said it saw no reason to alter its S&P 500 index projections for a year-end 8,100 and then 8,400 by June next year. The upsides of 6% and 10% follow last night’s close of 7,619.98, a level 11% higher so far this year but down from August’s record 7,799.

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The bond market is already pricing in nearly four US rate hikes over the next year, beginning at the conclusion of the Federal Reserve’s policy meeting on Wednesday evening.

The expectations have driven the 10-year Treasury yield from 4.2% at the start of the year to 5%, which UBS said had contributed to a meaningful adjustment in the S&P 500 valuation from roughly 22 times earnings to around 19.5 times.

It added: “Put differently, the bulk of the valuation adjustment associated with Fed tightening may have already occurred.

“For long-term yields to rise materially from here and put further pressure on equity valuations, investors would likely have to price in an even more aggressive path for monetary policy, in our view.”

UBS said its analysis of 16 hiking cycles since 1954 showed an average gain one year after the first Fed hike of 10.8%.

There’s yet to be a bear market - defined as a decline of 20% or more from the recent high - although the last hiking cycle in March 2022 was the worst performing of all with a 9% reverse.

The bank said the straightforward reason why the first Fed hike is not, by itself, a reliable signal to reduce equity exposure is that a central bank typically begins raising rates because economic growth is healthy and inflation pressures are building.

It added: “Those same conditions are often supportive of corporate profits. As a result, earnings growth can continue to offset the valuation headwind created by somewhat higher interest rates.”

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UBS said the current outlook for economic growth, corporate earnings and inflation appeared more consistent with continued expansion than imminent contraction.

It added: “Manufacturing activity remains in expansion territory, and our previous work has shown that manufacturing upcycles tend to persist for considerably longer than the current cycle has been in place.

“Furthermore, we continue to expect strong growth in AI investment spending into at least 2027, which will drive profit growth for the ‘picks and shovels’ providers. Hyperscaler investment plans already indicate a commitment to solid growth in 2027.”

However, UBS believes that the biggest medium-term risk to the equity outlook remains the trajectory of AI infrastructure investment. Higher interest rates can increase the cost of capital and make financing massive data-centre projects more difficult.

It added: “Over time, that could place pressure on parts of the AI ecosystem. However, we believe substantially more tightening would likely be required before financing conditions become a meaningful constraint.”

For now, the bank thinks earnings growth is on a solid footing and will continue to be the main driver of further equity market gains. UBS expects S&P 500 earnings will grow by 25% in 2026 and 14% in 2027.

This compares with Bank of America’s new forecast for a current year rise of 33% to $365 a share, which represents a 6% hike on its previous estimate after Corporate America delivered another outsized earnings beat in recent second-quarter results.

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The bank expects growth to decelerate in 2027 although a forecast rise of 12% to $410 is still above trend, driven by the AI investment cycle, manufacturing strength and productivity gains.

Risks include reliance on the AI buildout after noting that five stocks - NVIDIA Corp (NASDAQ:NVDA), Alphabet Inc Class A (NASDAQ:GOOGL), Micron Technology Inc (NASDAQ:MU), Microsoft Corp (NASDAQ:MSFT) and Apple Inc (NASDAQ:AAPL) - now account for a record 27% of next 12-month S&P 500 earnings.

And semiconductor stocks alone are expected to contribute over 60% of the total consensus earnings per share growth in 2027.

Although encouraged by the fundamental backdrop, it said worsening liquidity, geopolitical tensions, sticky inflation and unfavorable seasonal trends were reasons for near-term caution.

The bank yesterday nudged up its year-end target for the S&P 500 to 7,400 and launched its 12-month target at 7,800, which it said was “nothing to write home about”.

It believes there’s likely to be a better entry point, given that March has been the only time the benchmark has declined by 5% or more this year compared with the typical three per year. Contractions of 10% or more happen once per year on average, but the last was spring 2025.

BofA said about 50% of its bear market signposts are triggered, which is not as bad as 70% seen in May-June but still elevated. However, the bank adds that productivity gains mean the long-term bull case for US equities is intact.