From COVID stress, to a blowout recovery, to an earnings recession, to prodigious growth from the biggest names in Tech, earnings have been through a lot these past few years. But as growth and inflation normalize, so too should earnings.
In brief
- S&P 500 earnings are stabilizing with nominal GDP, 3Q24 EPS is estimated to grow 5.4% y/y and 2.6% q/q.
- Big tech earnings growth is prodigious but decelerating, while financials and health care show strong performance.
- Monetary and fiscal stimulus could boost energy, industrials and materials, driving the next wave of the broadening.
- Moderate growth is supportive of equity returns, and rate cuts could aid a cyclical recovery and diversify opportunities.
From COVID stress, to a blowout recovery, to an earnings recession, to prodigious growth from the biggest names in Tech, earnings have been through a lot these past few years. But as growth and inflation normalize, so too should earnings. Indeed, 3Q results suggest S&P 500 earnings growth is reverting towards trend. With 343 companies (74.8% of market capitalization) reporting, our current estimate for pro forma earnings per share (EPS) is USD 62.10. If realized, this would represent a year-over-year ( y/y) growth of 5.4% and a quarter-over-quarter (q/q) growth of 2.6%.
At the start of the quarter, analysts were predicting 3Q24 EPS growth of 7.3% y/y and 10.8% for 2024. However, given expectations for trend-like gross domestic product (GDP) growth, these seemed too rosy compared to the 10-year average of 8.1%. Since then, the 3Q estimate has been revised down by more than average, while the 2024 estimate now sits at 9%. Current estimates for 4Q, 2025 and 2026 of 12.4%, 14.6% and 12.7% are likely to meet a similar fate. The economy can amble along for a while, but not at the breakneck pace that would drive earnings growth of this magnitude.
3Q EPS estimates were revised down by more than usual
Nevertheless, companies are holding up well. So far, 75% have beaten on earnings, slightly below the 5-year average of 77%, and actuals are 4.7% above estimates. Sales are weaker, with 62% of companies beating compared to the 5-year average of 69%. Of the 5.4% expected growth in EPS, revenues, margins and buybacks should contribute 5.4, 0.9 and -0.9 percentage points respectively. In 2022, inflation, wage growth and supply chain issues plagued profitability. In 3Q24, five sectors are still reporting margins below five-year averages. Normalizing costs, particularly in the health care and materials sectors, will be a source of earnings growth moving forward. Additionally, as rate and policy paths crystalize, companies are more likely to reinvest excess cash into their businesses rather than return it to shareholders. Revenue growth will therefore be an increasingly important driver of future earnings.
Exhibit 1: Margin recovery should be a source of future earnings growth
Pro forma EPS, y/y
Source: FactSet, J.P. Morgan Asset Management. *3Q24 and 4Q24 numbers are forecasts based on consensus analyst expectations.
The leading big tech companies are still crushing expectations, but capex is a concern
Of course, the most important drivers these past two years have been the 7 mega-cap tech or tech adjacent companies that make up what is popularly called the Magnificent 7. That isn’t likely to change this quarter. Analysts estimate that their earnings will grow by 27.2% y/y compared to 0.5% for the remainder of the index. On a full year basis, they are expected to grow earnings by 36.2% versus 3.1% for the rest of the index. However, the focus this quarter isn’t the eye-catching earnings; it’s the eye-popping spending on artificial intelligence (AI). These 7 names are growing capital expenditures by an estimated 42% this year to arm themselves in the battle for technological supremacy. They are not slowing down anytime soon either; J.P. Morgan estimates their capex will grow another 14% in 2025. Including research & development, their total investment in AI is expected to reach USD 500 billion per year.1
Although investors are increasingly concerned about returns potential, CEOs believe underinvesting is far riskier than overinvesting. Companies have highlighted billions in incremental revenue, an estimated 30% boost to software engineering productivity, and profitable products in the pipeline.2 Plus, these companies are not spending money they don’t have; they remain of the highest quality with free cash flow yields of 25%. 2024 capex estimates may have risen 19% since 4Q22, but earnings and free cash flow estimates have been revised up too.
Their share of S&P 500 EPS growth is decreasing, reducing risk at the headline level. Though the broadening is on pause this quarter, the second derivate shows it is still very much in play. As earnings growth decelerates, it is accelerating for the remainder of the index. In 2023, earnings for the S&P 500 ex-Magnificent 7 contracted by 4%. However, analysts are expecting them to contribute 29% of the growth in 2024 and 73% in 2025.
This quarter, 8 out of the 11 sectors are actually contributing positively, but cyclicals are slumping. Energy, industrials, and materials earnings have been in the doldrums with U.S. manufacturing activity for the past two years. Crude oil and natural gas prices averaged 75.5 and USD 2.2 compared to USD 83.1 and USD 4.2 over the past three years, hurting energy sector profitability. Weakness in materials is broad-based but acute in metals & mining, given China’s importance in commodity demand. However, the winds are changing. Manufacturing activity has been subdued as businesses paused durable goods investment until interest rate and regulatory outlooks clarify. The Federal Reserve rate cutting cycle and the election results should remove some of that uncertainty. Moreover, U.S. fiscal spending related to energy and supply chain security plus renewed stimulus efforts in China should be a significant tailwind. A recovery in these cyclical sectors could drive the next phase of the broadening.
Investment implications
Although nominal U.S. growth is downshifting, moderate growth coupled with low recession risk has historically been a supportive environment for equity returns. Even though the U.S. economy is slowing, investment opportunities are growing. Rate cuts should support a cyclical recovery, allowing less-loved sectors to join the tech party. This, in turn, should ease concentration and valuation risk at the index level. As we move deeper in the cycle, it is critical to ensure growth’s outperformance has not left portfolios offside. Proper protection will enable investors to capitalize on pockets of exceptionalism. Markets are not the economy, and with secular tailwinds and easing U.S. monetary policy, equities should be able to generate compelling returns for some time to come.