Q3 Earnings Recap: Steady As She Goes

SUMMARY

• US large-cap earnings results remain strong, and small-caps improved for the second quarter in a row.
• Japan improved from last quarter; Europe’s improvement was less consistent.
• We saw little evidence of tariff impact, strong evidence of solid AI earnings, and some signs of value stock improvement.

With over 90% of S&P companies now having reported for the third quarter, 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?

We are watching this earnings season for three major themes:

1. We want to be aware of any complications from tariffs that might lead to breakdowns in earnings.
2. We want to be attuned to any slowdowns in AI-themed sectors – our base case has been that these companies can earn their way into their valuations.
3. We want to look for any areas where ‘value’-oriented companies are beginning to demonstrate strong earnings growth – we believe this is a distinct possibility in a number of markets and view it as a potential sign of market health.

Looking closer at US large-caps, starting with the first principle, we are encouraged that so far tariffs have not put a dent in US earnings relative to expectations; the S&P 500’s earnings were +6.3% higher than anticipated (source: Bloomberg), with every sector but Communication Services beating expectations. Communication services is a bit of an outlier, as Meta and Netflix both recorded large one-time tax hits that are not directly attributable to core operations, in our view. Setting aside this outlier, these results appear to corroborate our positive view on earnings. More specifically, we believe that the combination of stable interest rates and sustained inflation levels between 2-3% percent have created an environment whereby business models with high fixed costs, but low variable ones (a feature called ‘operating leverage’) can thrive, despite tariffs.

From a revenue perspective, we were also encouraged by sales coming in +2.1% higher than analysts expected, with all 11 sectors showing positive revenue surprises. This also allays our fears that tariff impact might be worse than the analyst community feared, and points to growth that is better than analysts expected.

Moving to our second principle, future earnings expectations for the S&P 500 over the next 12 months have ticked upward in response to positive earnings surprises (see Chart 1, above). Similar to our take on sales surprises, analysts have continued to see a way for US large-cap to continue growing earnings.

Finally, the annualized trend of US large-cap earnings continues to be a positive +13.1% year over year overall, supported by revenue growth of +8.3%. While all 11 sectors showed positive revenue growth, Communication Services and Energy were the only sectors to have negative earnings growth. As we mentioned earlier in the piece, the Communications Services miss was primarily tax-related and weak energy earnings are largely a function of declining energy prices. So, if we are looking for tariff warning signs in this data, there do not seem to be many that can be fully attributed to them. We also see strong top and bottom-line growth in Financials and Industrials, two sectors we consider prime candidates for the “value rotation”.

Most importantly to the AI theme, it appears that Technology - with +29% annualized earnings growth compared to a 23% price return over the year to date - is fully justifying its’ strong performance with exceptional earnings growth through the period. We view continued earnings growth as necessary to support further returns, given elevated valuations and risks around AI Investing busts (as discussed in our last Weekly View).

Small-Cap Improving but Still Less Consistent Than Large-Cap; International Improving as Well

The table above summarizes RiverFront’s view of the earnings picture for four different market segments: US large-cap, small-cap, Europe and Japan. Relative to US large-caps - which have a clear growth/technology bias – US small-caps, Europe and Japan all have a greater weighting in more value-oriented sectors. Again, due to operating leverage, we believe these themes should begin to respond positively to a macro environment of falling short rates and modest (2-3%) US inflation.

As such, while we look for continued strength in larger US companies, in these other markets we instead are looking for improvement. In the table above, the “+” and “-“signs indicate our view of how things have changed since the previous quarter. Note we added a number for each surprise / growth that indicates how many of the sectors are positive out of the 11 GICS sectors. We did this to show how consistent / pervasive the general trend is; note that the estimates are still done at the market level, so we just get one value.

Beyond Large Cap: Other ‘Value-led’ market segments mixed… US Small-Caps and Japan doing better than Europe

• US Small-Cap: Small-cap earnings continue to improve, although the sector-by-sector revenue and earnings story is more mixed versus large-caps. Taking this improvement in tandem with the potential for interest rate cuts, we believe there is a strong case for small-cap as an investment, although the inconsistency across sectors means that selection will be critical. Some potentially attractive sectors in our view include technology, industrials and healthcare, given the strengths of their earnings. We view small-cap earnings trends as showing similar resilience to tariffs, strength in AI themes, and budding earnings pickup in ‘value’ sectors as their larger-cap brethren.
• Europe: Looking through our framework, European equities have improved since the last quarter. However, results are much more inconsistent across sectors and generally lower than US large-cap, as epitomized by 3% earnings surprise vs 6.7% in the US. We see continued strength in Euro financials but mixed results in defensives, cyclicals and growth sectors. We will watch for improvement here as the “re-armament” plans are implemented across the continent.
• Japan: Earnings bounced back strongly in Japan after weak results last quarter. This had the effect of flipping all five of our indicators positive from flat or negative. What we have not seen out of Japanese markets over the past year is consistency, so we want to see a little stronger trend in these numbers before drawing any concrete conclusions.

Conclusion: US Large-Cap Stocks Still Leading; Want to See More Consistency Elsewhere + AI Trade to Stay in Place

This was a strong quarter for US company earnings - both large and small - amidst a myriad of tariff and macro challenges. We have described corporate America as ‘exceptional’ and these numbers support that view, in our opinion. Europe and Japan also improved, although not as consistently as the US. We continue to see little evidence of tariffs causing large scale damage to earnings – we believe this is because the overall strength and resilience of the economy have overshadowed any disruptions that might have occurred. We also see very strong earnings out of AI-related segments, and some evidence of value-oriented sectors earnings beginning to accelerate.

Our portfolios are positioned consistently with the takeaways of this analysis, in our view. We are overweight US large cap stocks across our balanced portfolios, driven by the S&P 500’s demonstrated earnings strength. We have also made selective investments in Europe and Japan, with distinct tilts towards Value and Financials. We will also be watching for shifts in earnings trajectory from tariffs, the AI investment theme, or potentially a value rotation if lower interest rates set in. 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.