Q1 Earnings Recap: US Large-Cap Hanging In, Other Segments Showing Weakness

SUMMARY

• US large-cap earnings have continued to grow and surprise to the upside.
• European and Japanese expected earnings buoyed by currency; US small-cap is struggling.
• While tariff impacts will not show up fully yet in earnings results, estimates have held up so far…which we view positively.

With over 90% of S&P companies now having reported, we feel we have enough data to perform our quarterly earnings season ‘checkup’. In order to complete this checkup, we will use our three ‘earnings principles’:

1. Earnings/Revenue Surprises: Were corporate results out of alignment with market expectations?
2. Analyst Adjustments: What was the direction and magnitude of analysts’ estimate revisions after forward guidance was issued?
3. Earnings/Revenue Trends: What is the long-term earnings trend after the announcement?

Starting with the first principle, the S&P 500 posted another strong quarter relative to expectations; earnings were +8% higher than anticipated (source: Bloomberg), with every sector but Real Estate beating expectations. These results seem to corroborate our view that the combination of stable rates and sustained inflation levels between 2-3% percent has created an enviroment where ‘high operating leverage’ business models -ones with high fixed costs but low variable ones - can thrive. While we are encouraged by this earnings performance, we must continue to monitor the trends, given US policy volatility.

From a revenue perspective, we were also encouraged by sales coming in +0.8% higher than analysts expected, with only Staples and Financials coming in below expectations.

Moving to our second principle, future earnings expectations for the S&P 500 over the next 12 months remained largely stable in response to positive earnings surprises (Chart 1, above). This is critical in our view, since tariffs were announced after the end of Q1, so early signs of deterioration should start to show up here. To that end, we will be carefully watching surprises next quarter… but analysts’ forecasts holding up in the midst of such an uncertain trade backdrop is a positive sign, in our view.

Finally, the annualized trend of US large-cap earnings continues to be a positive +11.3% year over year overall, supported by revenue growth of +4.2%. Important to our thesis, earnings for ‘growth’ sectors (Technology, Communication Services and Discretionary) all have strong earnings growth, as do Health Care companies. Energy and Materials are struggling due to higher financing costs and declining commodity prices, while Staples and Real Estate both face margin pressure from interest rate increases.

This healthy checkup for growth themes is critical for US large-capitalization stocks as our constructive view of US returns is predicated on a continuation of strong earnings. While the effects of tariffs still could reveal weak spots in future earnings, all indications are that, so far, the price correction we saw at the end of the quarter was more a valuation reset than an early sign of a major earning correction in US large-cap stocks, in our view.

US Large-Cap Holding Up While Other Segments are Showing Weakness

The table above summarizes RiverFront’s view of the earnings picture for four different market segments. Relative to US large-caps - which have a clear growth/technology bias – US small-caps, Europe and Japan all have a greater weighting in the more value-oriented sectors. As such, while we look for continued strength in US large-cap, in these other markets we instead are looking for improvement. Unfortunately, most of these other major segments outside of US large-caps have seen more mixed results. In the table above, the “+” and “-“ signs indicate how things have changed since the previous quarter. The biggest trend to note is that, unlike US large-cap, each of the other segments experienced deterioration in both surprises and in their growth rates.

Beyond Large-Cap: Other ‘Value-Led’ Market Segments Mixed…Europe Faring Better than Japan or US Small-Caps

• US small-cap: A perceived economic slowdown, some fear of tariffs, and the Fed making clear that rate cuts would be fewer than were broadly expected all combined to create some meaningful deceleration in US small-cap from an earnings standpoint. Critically, unlike Europe and Japan, earnings estimates for small-cap have fallen in tandem with prices. This combination of falling prices, declining earnings and profitability and deteriorating fundamentals are creating the heightened possibility of a “value trap” in smaller companies, in our view.
• Europe: European equities, on paper, look to have had a rough go as well for Q1 earnings. However, we believe there are two things that are working in Europe’s favor that might not be immediately apparent. The first is that estimates have strengthened meaningfully during this period, which means that combined with stronger than expected Q1 earnings, there is some evidence of the beginning of positive momentum in European earnings. The second is that our analysis looks at all earnings in local currency. This fact ignores the strength of the euro, which during the period significantly elevated the value of those earnings. Given our view that policymakers in the US are not seeking a strong dollar in the near term, we think it is likely that this elevation of European earnings in dollar terms will persist for some time.
• Japan: Results here are definitely better than US small-caps, but nowhere near as compelling as Europe, in our opinion. Japan benefitted from the yen gaining ground on the dollar, but its earnings and revenue growth numbers were all weak in local terms. Like Europe, it did benefit from increased expectations in earnings growth for the next couple of quarters, which is critical as Japanese equities stare down tariff risks.

Conclusion: Still Favoring US Large-Cap Stocks; Beginning to Lean into Europe and International

The good news is that earnings expectations everywhere have not turned negative with the myriad announcements surrounding tariffs and the trade war. We have seen some small signs of weakness, but overall, our earnings analysis paints a cautiously optimistic picture for almost every segment, with small-cap being the notable exception given fundamental and interest rate headwinds it faces.

Our portfolios are positioned consistently with the takeaways of this analysis. We are overweight US large-cap stocks across our balanced portfolios. Our conviction on large-caps is due in part to their demonstrated earnings strength. We have also made selective investments in Europe and Japan, and have risk-managed small-caps out of our long-horizon portfolios. Over the next quarter, we will need to see some improvement in the realized earnings growth trends of European and Japanese markets. With the impact of tariffs creating uncertainty, we will be monitoring corporate surveys, business confidence, earnings guidance and analyst revisions to assess whether the risk of recession has increased

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.