Goldman Sachs' David Kostin on US Earnings, Tariffs, Mid-Cap Stocks

Summary

In this discussion, the speaker shares an optimistic outlook for U.S. equities, projecting an 11% upside for the S&P 500 index, with corporate earnings expected to grow by 11% in 2025. However, concerns regarding high bond yields, the strong dollar, and potential tariffs loom as risks for the market. The speaker also highlights a shift toward mid-cap stocks, which offer better risk-reward ratios compared to large-cap stocks. While U.S. investors are cautious about direct exposure to China, they show more interest in accessing Chinese growth via U.S. equities.

Takeaways

• 😀 The S&P 500 is expected to rise to 6500, indicating an 11% potential upside in 2025, driven by around 11% earnings growth in that year and 7% in 2026.
• 😀 Fourth-quarter earnings season is expected to show around 8% growth, but the impact of a strong dollar could reduce the typical earnings surprise from the previous years.
• 😀 Earnings growth is the main driver for the U.S. equity market, rather than multiple expansions, as the S&P 500 currently trades at a high multiple (22-23x forward earnings).
• 😀 Elevated bond yields are a concern, as they have risen rapidly by 50 basis points in just one month, which has historically been a headwind for equities.
• 😀 The expectation is that inflation will decline slowly, which should lead to lower bond yields (around 4.25% nominal yields) later in the year, offering relief to equities.
• 😀 Inflationary pressures could rise due to potential tariffs under Trump, particularly affecting companies with significant revenue exposure to China, like Tesla, Apple, and Nvidia.
• 😀 Portfolio managers are focusing on U.S. companies with domestic revenue, avoiding those with high international exposure, as retaliatory tariffs are likely to target export-oriented businesses.
• 😀 Mega-cap companies, especially those with large international revenue exposure, face potential risks, with approximately 50% of their sales coming from outside the U.S.
• 😀 The strong performance of large-cap stocks is expected to moderate in the coming years, with earnings growth for these companies likely narrowing from 30% in 2024 to just 3% by 2026.
• 😀 Mid-cap U.S. stocks, trading at much lower multiples (16x forward earnings) compared to large-cap stocks, represent a more favorable risk-reward opportunity, with similar growth rates and stronger long-term outperformance.

Q & A

What is the expected outlook for the S&P 500 index in 2025 and 2026?

The S&P 500 index is expected to rise to around 6500, representing an 11% gain from its current level. Earnings per share are projected to grow by 11% in calendar 2025 and 7% in calendar 2026.

How does the upcoming fourth-quarter earnings season look for U.S. equities?

The fourth-quarter earnings season is expected to show a growth of around 8%. However, the strong dollar in this quarter is likely to lead to fewer positive earnings surprises compared to previous years.

How has the strong dollar impacted corporate earnings growth?

The strong dollar, particularly in the fourth quarter, has been a headwind for earnings, leading to smaller earnings surprises than seen in previous years. Typically, positive surprises are around 400 basis points, but this quarter is expected to be somewhat less.

What role do bond yields play in the equity market outlook?

Higher bond yields have historically been a headwind for equities, especially when bond yields rise swiftly, as seen with a 50 basis point increase over a one-month period. However, it’s expected that inflation will come down slowly, leading to a decrease in bond yields to around 4.25% by the end of the year.

What is the expectation for bond yields in the coming months?

It’s expected that bond yields will fall gradually over the rest of the year, potentially reaching around 4.25% in nominal yields, down from current higher levels.

How might Trump's potential tariffs impact U.S. companies with exposure to China?

Companies with a high percentage of their revenue coming from outside the U.S., particularly from China, face risks from potential tariffs, as these companies are more vulnerable to retaliatory measures. The recommendation is to focus on U.S.-domiciled companies with a large share of domestic sales.

What is the potential risk to companies with significant exposure to China?

The primary risk to companies with significant sales in China is the potential for retaliatory tariffs, which could impact earnings. This is especially concerning for large companies, including those referred to as the 'Magnificent Seven,' with around 50% of their sales coming from abroad.

How has the performance of large-cap companies in 2023 and 2024 been different from mid-cap stocks?

Large-cap companies in the 'Magnificent Seven' have experienced exceptional stock performance in 2023 and 2024, driven by premium earnings growth. However, this premium growth is expected to narrow in the coming years, with mid-cap stocks offering a better risk-reward profile due to lower valuation multiples.

Why are mid-cap stocks recommended as a better investment currently?

Mid-cap stocks, trading at much lower multiples (around 16 times forward earnings), are seen as having a better risk-reward profile compared to large-cap stocks, which trade at 22-23 times forward earnings. Mid-cap stocks also offer similar growth rates to large caps but at a more attractive valuation.

Is there significant interest from U.S. investors in relocating to China?

There has not been significant interest from U.S. investors in relocating to China. Instead, U.S. investors are more focused on gaining exposure to Chinese markets via U.S.-listed companies rather than investing directly in Chinese companies.