Profits Are Holding Up and Other Key Takeaways from Q2 Earnings Season

Introduction

U.S. markets were relatively calm Monday as Wall Street entered the home stretch of second-quarter earnings season after a volatile week of trading fueled by recession fears. Trading activity often picks up during the month or so every quarter in which America’s largest companies report results. But this past month, especially the last two weeks, has been characterized by abnormal swings in the stock market. Volatility spiked last week to its highest since the onset of Covid-19 after a soft jobs report and a rate hike from the Bank of Japan sparked a multi-day sell-off. Those intervening factors, as well as political uncertainty, have clouded the outlook for U.S. equities coming out of what has for the most part been a solid earnings season. Below, we look at some of the major themes that have characterized this past quarter’s earnings reports.

Profits Are Holding Up

The S&P 500 as a whole was on track to report earnings growth of 10.8% as of Monday, according to data from FactSet. If that ends up being the actual growth rate once all 500 companies have reported, it will be the index’s highest since the fourth quarter of 2021 (31.4%). And companies have so far beat earnings estimates at a rate (78%) slightly above both the 5-year (77%) and 10-year (74%) averages. However, the magnitude of those beats (3.5% on average) has lagged the norm (8.6% over the last 5 years), suggesting some weakness lingers below the surface.

Sales Lagging Earnings

Despite resilient earnings, revenue growth has lagged profit as consumers and businesses alike have reined in spending. The S&P 500 is on track to report revenue growth of 5.2% for the quarter, below the 5-year average of 6.7%. And the percentage of companies reporting better-than-expected revenue is also below the 5-year average. Top lines have been squeezed in recent quarters by inflation-pinched and cost-conscious consumers. But not every company has felt the pain equally. Burger chain Shake Shack (SHAK) reported its second consecutive quarter of double-digit revenue growth, while competitor McDonald’s (MCD) saw same-store sales decline in the second quarter. Analysts have attributed the disparity to the widespread perception that the price gap between fast-food chains and “fast-casual” restaurants like Shake Shack, Chipotle (CMG), and Sweetgreen (SG), has narrowed in recent years. Executives have also noted the pressure that inflation, a slowing economy, and the evaporation of pandemic savings have put on lower-income Americans.

Wall Street Sours on Big Tech’s AI Spending

Big Tech companies are spending big on artificial intelligence, and they don’t plan to stop anytime soon. Alphabet (GOOGL) and Microsoft (MSFT) increased their capital expenditures (CapEx) by 91% and 55%, respectively, in the quarter, with much of that increase going toward semiconductors and other hardware for AI-powering data centers. Both companies said they expect to spend even more in the next year. The cost of Big Tech’s AI arms race scared Wall Street last month. The Magnificent Seven stocks notched a few of their worst days on record during the two weeks when most of the group reported earnings. The stocks will be tested again when chipmaker Nvidia (NVDA) reports earnings on August 28. That cloud providers have spent so profusely on AI hardware bodes well for Nvidia’s sales, but expectations are high after four consecutive quarters of triple-digit revenue growth. Even with its recent pullback, the stock could be hit by signs of weakening demand or evidence substantiating reports its next-generation Blackwell chips will be delayed by a design flaw.

Financial Sector Itching for Rate Cuts

The financial sector has reported the third-largest increase in earnings of any sector this quarter. Profit grew by 17.6% from the same quarter last year, and all five sub-industries—Insurance, Capital Markets, Consumer Finance, Financial Services, and Banks—have reported earnings growth. Elevated interest rates were once a boon to big banks, some of the sector’s largest players, as the interest they collected on loans grew. But their deposit costs have since caught up, eating into net interest income, a key financial metric for the industry. Now, with the Federal Reserve appearing poised to cut interest rates from their highest levels in decades, the sector approaches an inflection point. Lower interest rates could again pad banks’ interest margins as their deposit costs decline at a faster clip than their income from fixed-rate loans. The sector could also benefit from a pick-up in loan demand and a dash of relief for cash-strapped consumers, among whom credit card delinquency rates recently climbed to a 12-year high.

In conclusion, despite some volatility and uncertainty, second-quarter earnings season has shown that profits are holding up for many companies. However, sales growth has been slower, indicating some underlying weakness. Big Tech’s spending on AI has raised concerns on Wall Street, while the financial sector is hoping for rate cuts to boost their earnings. These key takeaways provide insights into the current state of the market and the factors influencing it.