As the third-quarter corporate earnings season begins, investors are closely monitoring company reports for insights into several key economic pressures. After a significant rally in U.S. stocks, driven largely by enthusiasm for artificial intelligence, expectations are high, leaving little room for companies to miss their financial targets.
Market participants will be scrutinizing financial statements and executive guidance for details on the impact of international trade tariffs, the sustainability of AI-related capital expenditures, and the health of the labor market. These factors, combined with currency fluctuations and China's economic performance, will shape market sentiment for the remainder of the year.
Key Takeaways
- Analysts expect a 7.4% profit growth for S&P 500 companies in the third quarter.
- Five critical themes are in focus: ongoing trade tariffs, the level of AI investment, labor market stability, currency exchange rates, and China's economic outlook.
- High stock valuations, with the S&P 500 up 11% year-to-date, mean investors may react strongly to any sign of weakness.
- The durability of spending on AI infrastructure is a central question for the technology sector and its global suppliers.
Trade Tariffs and Supply Chain Pressures
Renewed tensions in global trade are a primary concern for investors. On Friday, President Donald Trump announced plans for an additional 100% tariff on Chinese goods and new export controls on critical software, scheduled to take effect on November 1. This move has placed the impact of trade policy back at the forefront of market analysis.
Analysts believe that months of elevated tariffs are already affecting corporate profitability. According to a report from Deutsche Bank AG, earnings growth for S&P 500 companies would have been one percentage point higher in the third quarter without the existing tariffs.
Eric Freedman, chief investment officer at U.S. Bank, noted that investor patience is wearing thin. While companies were given a "hall pass" on vague guidance in previous quarters, Freedman believes the market now demands more clarity. "We would expect there to be more both clarity from companies, but then also more responses from investors about what they’re willing to tolerate," he said.
Global Impact of Tariffs
While Asian economies have shown some resilience, analysts suggest this may be due to companies front-loading exports to get ahead of new tariffs. In Europe, consistent downgrades to earnings estimates since March indicate that the market has already priced in much of the negative impact, potentially lowering the bar for companies reporting soon.
The Sustainability of AI Investment
The global stock market rally has been significantly fueled by massive corporate investment in artificial intelligence. This spending spree has boosted a wide range of companies, from chipmakers to the firms that build and service the underlying infrastructure. The key question for investors is whether this level of spending can continue.
Capital Expenditure at Record Levels
Global capital expenditures are expected to grow by 67% this year to $375 billion, according to UBS. Separately, strategists at Societe Generale report that the ratio of capital expenditure to sales is at its highest point in 25 years, highlighting the intensity of current investment cycles.
Any indication that companies are scaling back their AI investments could trigger a sharp market correction. Mike O’Rourke, chief market strategist at JonesTrading Institutional Services LLC, described a potential slowdown as being like "slamming on the brakes." He warned, "I would expect you’ll see a lot of the names enter a real profit-taking mode."
A pullback in U.S. spending would have global ripple effects. European companies involved in power generation and telecommunications, which are crucial for AI infrastructure, have seen significant gains this year. Similarly, Asian semiconductor firms have surged, but concerns about high valuations are growing.
Labor Market Signals Amid Data Scarcity
Investors will also be looking for clues about the U.S. labor market. With a federal government shutdown making official employment data unavailable, corporate reports on hiring and firing plans will take on greater significance. These announcements will serve as a key proxy for the health of the economy.
Widespread reports of layoffs could fuel fears of a slowdown in consumer spending, which would negatively affect retailers, restaurants, and other consumer-facing businesses. Ross Mayfield, an investment strategist at Robert W. Baird & Co., highlighted the delicate balance.
"If you see enough of those start to stack up, especially if we’re still in the absence of any official data, then it’s a signal that the labor market is weaker than expected. It’s a narrow landing strip."
Corporate commentary on headcount will be one of the most closely watched elements of this earnings season, providing a real-time indicator of business confidence.
Impact of Currency Fluctuations
The value of the U.S. dollar is another important factor. Although the dollar has strengthened recently, it remains lower than it was a year ago. This relative weakness acts as a tailwind for U.S.-based multinational corporations and exporters.
A softer dollar makes American products more competitive abroad and increases the value of foreign profits when converted back into dollars. Jeff Buchbinder, chief equity strategist at LPL Financial, suggested this could be a significant boost.
In a recent report, Buchbinder stated that the weaker currency, combined with other factors, could add "another 5-7% upside to current consensus estimates."
Challenges for European Exporters
In contrast, European companies are likely to face headwinds from a relatively strong euro. While the currency has weakened slightly, the change came too late in the quarter to benefit the current earnings reports. Susana Cruz, a strategist at Panmure Liberum, noted this could be problematic, as companies in the Stoxx 600 index generate approximately 60% of their sales internationally.
Monitoring China's Economic Health
Finally, investors are watching for signs of how China's economy is navigating the global trade conflict. While China's CSI 300 stock index has risen 17% this year, profit expectations remain modest, with analysts projecting just 3% growth for the third quarter, according to data compiled by Bloomberg.
The economic outlook could worsen if trade tensions escalate further. However, some positive signs are emerging. Goldman Sachs noted that the pace of earnings downgrades in China is slowing, supported by improved factory activity and industrial profits.
Additionally, the Chinese government's efforts to curb "involution"—a term for destructive internal price wars among domestic companies—are viewed favorably by some investors. Vey-Sern Ling, managing director at Union Bancaire Privee, commented on the situation.
"Earnings may improve sequentially as the government cracks down on involution," Ling said. He added that for many tech-focused companies, future guidance on AI progress might be more important to investors than current earnings figures.