Q3 Earnings Season Begins: Strong Performance in Banking, Mixed Outcomes for Chip Sector
The third quarter earnings season commenced recently, showcasing robust performance from major banks and mixed results within the semiconductor sector. Prominent banks, including JPMorgan, Goldman Sachs, Morgan Stanley, Bank of America, and Citigroup, surpassed earnings expectations. This success was partially attributed to increased investment banking fees and trading revenues compared to the previous year.
Conversely, early reports from the AI-related chip sector indicated mixed outcomes. Taiwan Semiconductor Manufacturing Company (TSMC) anticipates that revenue from cutting-edge AI chips will more than triple this year. However, ASML reported that orders for chip-making equipment fell below analyst expectations, mainly due to diminishing demand for legacy chips utilized in PCs, smartphones, and vehicles.
Expansion Beyond "Mag 7" Mega Caps in S&P 500 Earnings
The S&P 500 is expected to see a projected 2.9% increase in earnings for the third quarter, marking the fifth consecutive quarter of positive earnings growth. While the "Mag 7" mega caps continue to be leaders, there is a notable broadening of earnings among other large-cap companies. Year-to-date, forward earnings for the remainder of the S&P 500 have increased by over 10%, although still trailing behind the 25% growth seen in the "Mag 7".
Record Highs in the S&P 500 Beyond "Mag 7"
Despite strong earnings growth, the "Mag 7" companies have not reached record highs in share prices for the past three months, currently sitting 4% below July’s peak. In contrast, the rest of the S&P 500 has achieved 17 new record highs within the last three months, supported by rising earnings.
The Impact of AI Investments on "Mag 7" Companies
A significant portion of the gains for the "Mag 7" has been driven by optimism surrounding artificial intelligence. However, this also requires substantial investment. Companies such as Amazon, Google, Meta, and Microsoft are projected to have a combined capital expenditure of $231 billion this year, a 56% increase from the previous year. Investors are now seeking tangible results from these AI investments before further increases in share prices.
Challenges for Small Caps Amid Rate Adjustments
While earnings are extending beyond the "Mag 7" to other large-cap sectors, small-cap companies have yet to experience similar growth. The S&P 600 small caps are poised for another quarter of negative earnings growth, continuing a trend observed over the past two years.
A primary challenge for small caps lies in their higher exposure to floating rate debt compared to large caps, which has resulted in tighter margins during the Federal Reserve’s rate hike cycle. With the Fed transitioning to rate cuts at the end of the third quarter, small-cap earnings are not expected to turn positive until the fourth quarter and into 2025, as further rate cuts potentially relieve margin pressures.
Overall, while large caps are experiencing broader earnings expansion, small caps continue to await their opportunity for growth.
