Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: Fed Chair Janet Yellen testified in front of Congress this week, and for the most part, indicated the Fed is maintaining course on a gradually normalizing interest rate. However, she did leave the door open to adjust policy if low inflation persists. What did you make of these comments?

Stovall: Well, they are in line with our expectations because on a year-over-year basis, Core CPI is up only 1.7%, which is in the lowest quintile of inflation since 1948. Therefore, I think it puts the Fed in a difficult position. They don’t want to be raising rates too aggressively while inflation remains below trend. So, I think the Fed is basically saying that the data will continue to define their monetary policy, but if inflation remains stubbornly low, they might end up pausing or even ending the rate-tightening program sooner than expected.

EQ: Earnings season kicks off this week as the big banks are on deck to report their Q2 results at the end of this week. In terms of EPS growth rate, the second quarter is expected to be the softest of the four in 2017. What is Wall Street expecting to see?

Stovall: Wall Street is expecting to see a little more than a 6% gain for the entire S&P 500. Six of the 11 sectors are expected to be in positive territory, led by a triple-digit gain by Energy, followed by double-digit increases for Technology and Financials. On the softer side, we’re looking for declines of more than 8% for Utilities, as well as a 3.5% decline for Industrials, and more than 2% decreases in Consumer Discretionary and Real Estate.

So, yes, this quarter is a bit more challenging than some of the other ones, primarily because it was in the second quarter of 2016 in which we were emerging from the earnings recession. So, as we move forward, the year-over-year comparisons will become a bit more challenging.

EQ: Considering the robust results we saw in Q1, could the table be set for some surprises in this reporting period?

Stovall: Maybe not in this reporting period, but in future reporting periods I think there is a possibility, because let’s remember that almost 50% of the revenues for the companies in the S&P 500 comes from overseas operations. So, should we get a strengthening in the US dollar, which is what we do not expect, then that could adversely affect overall S&P 500 earnings. It could also affect Energy and Technology because they have the greatest international exposure of the 11 sectors.

Also, should energy prices end up declining even more so in the second half of the year, then that could have a negative impact on the strong recovery expected to be seen from the Energy sector. We have done analysis and found that there is a 93% correlation between oil prices and Energy sector earnings. Should oil prices continue to soften, that could drag down the year-over-year gains for the S&P 500 Energy group.

EQ: In terms of corporate guidance, what are some broader issues or macro trends—aside from oil prices and dollar strength—that investors should keep a closer eye on for the second half and beyond?

Stovall: I think, overall, just look for growth in the economy. Are we seeing an increase in demand that is being inspired by an improvement in employment and driven by an increase in GDP? Or are we just seeing continued cost-cutting efforts? Also, take a look at share repurchases. Are they on the rise to artificially boost earnings per share?

I think that investors need to, in a sense, be suspicious of earnings increases and determine if they are real or manufactured. I think they would breathe a sigh of relief if they saw an actual improvement in economic activity rather than financial shenanigans.

EQ: That’s something we’ve discussed over a number of previous earnings reporting periods, where companies were growing earnings as a result of financial engineering. Have you noticed any positive trends from a top line growth perspective?

Stovall: We have. Revenues, which had been down a couple of years ago and flat last year, are expected to be up 5% this year. We most recently saw revenues up 8% for the first quarter, so the top line growth does seem to be justifying the bottom line improvements. Unlike the prior years, where it all seemed to be financial engineering, I think this time around it can be pointing to organic growth.