Q2 Earnings Recap: US Earnings Surprise to the Upside

• US large-cap earnings have continued to grow and surprise to upside.
• Europe, Japan and US small-cap, while weaker (and cheaper) are improving.
• If this proves sustainable, we see a potential rotation from Growth to Value and International.

At Riverfront, we use our 3 ‘Earnings Principles’ (detailed in this Strategic View commentary) to create a framework for “Bottom-Up” analysis of earnings and revenue. Boiling this framework down, we believe there are three key elements to earnings:

1. Earnings/Revenue Surprises: Were analysts’ opinions and corporate results out of alignment with expectations?
2. Analyst Adjustments: What do analysts think, and how did it change after the announcements about the future?
3. Earnings/Revenue Trends: What is the long-term earnings trend after the announcement?

Starting our analysis with surprises, the S&P 500 Index (representing US large-caps) had a strong second quarter relative to expectations (note all quarterly references are based on rolling 90 days as of 8/15). According to Bloomberg, earnings were 5.7% higher than anticipated, with only the Communications services sector missing analyst expectations in aggregate. Revenue was 0.8% higher than expected by analysts and was higher in all sectors except for Staples, Materials and Utilities. We expected the high short-term interest rate environment to create a difficult environment for defensive/low-growth sectors like Utilities and Staples, but issues in Materials were somewhat unexpected; we will continue to monitor this as a potential sign of global economic slowdown risk.

Analysts responded to earnings results by keeping numbers largely in line with expectations before the quarter. We would say this is positive overall – Chart 1, above, points to having strong earnings since 2022. We would also note unlike Q1 of 2024 earnings, estimates for 2024 declined slightly. While we believe this is not alarming, we will watch carefully for deterioration in the quarters ahead.

Finally, the trend of US large-cap earnings quarterly growth continues to be positive at +9.4% overall, supported by revenue growth of +4.7%. Important to our thesis, earnings for ‘growth’ sectors (Technology, Communication Services and Discretionary) are maintaining strong top line and bottom line results, and some ‘value’-oriented sectors (Financials, REITs, Utilities and Energy) are growing earnings despite a tough rate environment. As we contemplate the possibility of an investor rotation into value stocks, we are hoping these numbers strengthen in the quarters ahead. On balance, a positive trend growth rate, coupled with updated analysts’ views of growth into 2024 and 2025 provides an overall ‘healthy’ diagnosis for US large-cap stocks in our view.

The table below summarizes the earnings picture for these markets and compares them to US large-cap results:

When looking at this table, we would emphasize the improvement of the three “value-oriented” market segments (US small-caps, Europe, Japan) versus "their readings just a quarter ago,":https://www.riverfrontig.com/insights/encouraging-news-from-earnings/ as denoted by the “+” signs in the table above. While this improvement could reverse if a recessionary or stagflationary environment should take hold, it generally aligns with our belief that a reflationary environment is the more likely outcome.

US small-cap – Earnings growth still slow, but improving: We believe small-cap companies have been challenged due to their much shorter debt maturities and relatively higher leverage, which hurt profit margins more than their larger counterparts. Rising interest rates also caused smaller lenders to cut credit availability, which magnified these challenges for small-caps. "See this Weekly View on small-caps for more detail.":https://www.riverfrontig.com/insights/us-small-cap-why-now-is-not-the-time-to-buy/ Critically, we believe the shift in the market’s expectation for short term interest rates, if realized, could “unlock” the banking system and improve liquidity. This could substantially improve the potential for small caps’ earnings power as well as stock valuations. Thus, while small-cap earnings growth is weak currently in absolute terms, it is improving, and we know that any actual policy changes will show their impact with a lag. Assuming the Fed continues its course of lowering rates, we will look for continued improvement in the quarters ahead in small-cap earnings.

Europe – greatly improved from last quarter: We have long believed higher nominal growth from inflation should help value-oriented companies that are a hallmark of European equity markets. While the numbers are not as strong as US earnings yet, the marked improvement in earnings and surprises since last quarter provides some evidence that the environment is creating a fertile ground for earnings. The rebound in earnings momentum in Europe is interesting to us because, at a Price/Earnings ratio of 14.9x earnings, we think valuations are currently compelling.

Japan – steady on earnings, challenged with demographics and the yen: Japan continues to generate revenue and earnings that should be prized by investors. Unfortunately, the macro environment of Japan is challenging, debt and demographics are highly unfavorable. Furthermore, their attempts to bolster their undervalued currency in early August led to the worldwide collapse of what is known as the “carry trade” – where investors borrow money in Yen, where interest rates are low, to invest elsewhere. The sudden strength of the Yen forced investors to unwind their trades all at once. For Japan we believe the key to equity returns is successfully navigating these macro-oriented challenges.

From a portfolio perspective, we continue to favor stocks over bonds and there is little in the earnings analysis above to challenge that thesis. While inflation is slowing, we expect it to settle at a higher level than in the previous decade. Because of this belief, we think the benefits of sustained slightly higher inflation (higher nominal growth) are underappreciated by the market, which can lead to continued revenue surprises that should help all Equity Markets. We also prefer US Equities over international ones. This view is driven by the strong fundamentals of US companies, led by the biggest names, especially the technology-heavy “Magnificent 7”. Large-cap US stocks have longer maturity, lower cost debt as well as large cash reserves which has made them more resilient to high level of interest rates. Also, due largely to the high weighting in Technology, we see sustained higher earnings growth rates which we think are not fully reflected in share prices. The shifts in earnings we see in small-cap, Europe and Japan also opens the door to an increased investment in these segments.

As always, selection is key, and merging bottom up and top-down insights is critical in examining how policy is affecting profitability and our portfolio positioning. Since the macro outlook remains unclear, our focus in these improving areas from a bottom-up standpoint is on higher quality companies. While the tone of the Fed has shifted, short rates have not yet moved, and we should expect that weaker companies in any market segment could face major setbacks if their financing is squeezed by current higher rates.

For more news, information, and analysis, visit the ETF Strategist Channel.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.