Q3 earnings season starts strong for banks, mixed for chips
Q3 earnings season kicked off in the last week.
It started off with big banks - JPMorgan, Goldman Sachs, Morgan Stanley, Bank of America, and Citigroup - all beating earnings expectations, in part due to higher investment banking fees and trading revenues than a year ago.
However, a couple early reports for the AI-related chips sector were mixed. TSMC expects revenue for cutting edge AI chips to more than triple this year. But ASML reported chip-making equipment orders were less than half analyst expectations, seeing softer demand for legacy chips used in PCs, smartphones, and vehicles.
Mag 7 still leading the way, but earnings are broadening out to other large caps
For the S&P 500 overall, earnings are projected to grow +2.9% p.a. in the third quarter, which would mark the fifth straight quarter of positive earnings growth.
Once again, the mega cap Mag 7 is expected to lead the way. Importantly, though, earnings continue to broadened out beyond the Mag 7.
Forward earnings for the "rest" of the S&P 500 are up over +10% YTD (chart below, orange line) - still trailing the +25% growth for the Mag 7 (blue line).
Mag 7 now lagging as rest of S&P 500 sets new record highs on higher earnings
And yet, the Mag 7's strong earnings growth isn't translating to record high prices.
In fact, they haven't set a new high in 3 months and they're currently 4% below July's record (chart below, blue line).
But, in the last 3 months, the rest of the S&P 500 (orange line) have set 17 new record highs (as a group), boosted by rising earnings.
Part of the problem for the Mag 7 is that a lot of their gains over the last couple years are due to AI optimism, but AI requires a lot of investment. In fact, Amazon, Google, Meta, and Microsoft are projected to have capital expenditures of $231 billion this year. That's a 56% jump from just last year ($155bn).
So, at this point, it seems AI optimism is no longer enough. Instead, investors want some proof these AI expenditures will pay off before pushing share prices to new highs.
Small caps earnings recession to continue as they wait on more rate cuts
While earnings have broadened beyond the Mag 7 to other large caps, we're still waiting on that broadening to reach small caps.
After two straight years of negative earnings growth (chart below), the S&P 600 small caps are on pace for another quarter of negative earnings growth (orange bar).
One of the big challenges for small caps, as we showed a few weeks ago, is that they've got a 5x larger share of floating rate debt than large caps. So the Fed's rate hike cycle has squeezed small cap margins much more than for large caps.
With the Fed just pivoting to cutting rates at the end of Q3, small cap earnings aren't expected to turn positive until Q4 and into 2025 (green bars), as further rate cuts take pressure off their margins.
For now, Q3 looks like it continues the trend of earnings broadening out for large caps, but small caps are still waiting their turn.