Leaping over a lowered bar

Second quarter market volatility was enough to make anyone seasick. Competing waves of sentiment—tariff concerns versus artificial intelligence (AI) enthusiasm—tossed the S&P 500 from a 19% sell-off to new all-time highs by the end of the quarter. Catalyzed by trade talks, a 40% rally in the tech and communication services sectors propelled history’s fastest ever recovery from a 15%+ drawdown. As the market storm dies down, the 2Q earnings season should provide investors with a valuable opportunity to get their bearings.

Currently, consensus is projecting earnings per share (EPS) of USD 65.21. If realized, this implies year-over-year (y/y) growth of 7.7%, above the 10-year median of 5.3%. Looking at the three main sources of EPS growth, revenues, margins, and buybacks are expected to contribute 5.5, 3.1 and -0.8 percentage points, respectively. Tech is once again doing the heavy lifting, with the mega-cap U.S. tech companies expected to drive 56% of this quarter’s earnings growth. Financials is the only sector outside of tech outpacing S&P 500 earnings growth this quarter.

Only a small fraction of tariff costs hit companies’ 2Q results. Over the course of the quarter, consumer and producer inflation remained tame, with headline personal consumption expenditures price index (PCE) and producer price index (PPI) ticking up by 2.6% y/y and 2.3%, respectively, in June. Nevertheless, analysts revised down estimates for 2Q25 EPS growth by 4.0% between April 8 and June 30 (from 7.8% to 3.8%). So, while the percentages of companies beating earnings and revenue estimates are elevated (81% vs. 75% 10-year average for earnings, 79% vs. 64% for revenues), it is relative to a lowered bar. Surprisingly, analysts have not pushed this unmaterialized tariff hit into subsequent quarters. Since July 1, estimates for 3Q and 4Q y/y EPS growth have been revised up by around 0.5% each and downward revisions for the full year 2025 are in line with long-term averages.

AI enthusiasm trumps tariff concerns for now

In fact, U.S.  companies have been increasing guidance for both earnings and revenues, reversing the trend from April. This is partly due to lower-than-expected tariff rates, but it is also an acknowledgement of the powerful secular transformations driving revenue growth, first and foremost, AI. The mega-cap U.S. tech companies are on track to grow earnings by another 19% this year, and several achieved significant 2Q AI results. Cloud revenues grew at an average of 30% y/y, and AI is already driving double-digit increases in advertising monetization. This should give investors conviction in AI as an investment theme, but there is dispersion within the mega-cap U.S. tech companies, and there are also highly competitive companies outside the moniker. While estimates for S&P 493 2025 EPS growth have been revised down by 1.7% since April 8, estimates for the mega-cap U.S. tech companies have been revised up by 2.3%. Investments in AI also seem immune to macro and political uncertainty, which should support the broader tech sector. A lower U.S. dollar will be a tailwind for tech companies with a large proportion of sales outside the U.S., and the semiconductor industry stands to benefit from the relaxation of export controls to China. 

Companies are tackling tariffs costs

Tariff rates, particularly on China, will likely land significantly below those announced on April 8, which some companies used to provide guidance. Still, retaliatory and sectoral tariffs are a risk.

Supply chains were already more domestic and resilient post-COVID, and companies are implementing additional mitigation efforts. However, these do come with both U.S. dollar and opportunity costs.

Companies are inching up prices, but they are wary of demand destruction. Consumer confidence is low and tolerance for additional price hikes may be limited after the inflation in 2022.

Consumers remain relatively resilient…

U.S. companies appear to be adapting to higher tariffs, but the critical question is the resilience of consumer demand. Consumption grew 1.4% q/q saar in 2Q, accelerating from just 0.5% in 1Q. Although U.S. economic data indicates consumers remain stable, delinquencies and disparities between income levels are worth monitoring. While consumption may slow in the second half of the year, spending patterns are evolving with the environment. This has been reflected in 2Q earnings, with company commentary corroborating these shifts.

…but spending patterns are evolving.

So, where are consumers still spending? Chase data, retail sales, personal consumption expenditures data, and company results all echo some common themes.

Discretionary spending growth has been outpacing non-discretionary since 2024. So far in July, discretionary spend has been growing 6% y/y vs. 1.8% for non-discretionary. Health and personal care items top retail sales growth y/y, perhaps indicating that while consumers are not necessarily splurging on the big-ticket items, they are still enjoying simple luxuries. Categories such as electronics, appliances and recreational goods have been more subdued, but the monthly trend of real consumer spending shows some potential front-loading in the spring ahead of tariffs. Autos and auto parts experienced similar dynamics, although demand appears to have stabilized for now.

“Cracks in the consumer” has been a popular refrain over the last several years, but that has yet to materialize. While the consumer could shift from growing to slowing, companies remain cautiously optimistic about demand and are adapting their strategies to cater to pockets of resilience by offering value, innovation and simple indulgences.

Investment implications

Tech continues to boast impressive profits by monetizing AI, driving revenues, maintaining margins and benefiting from a lower U.S. dollar.

Financials is the only sector outside of tech outpacing S&P 500 earnings growth, supported by a steepening yield curve, a stabilizing macro backdrop and prospects for deregulation.

Consumer sectors tend to have slimmer margins and may be caught in the tariff crosshairs. However, pockets of resilience include simple luxuries, like dining, toys and beauty products, rather than big-ticket items. Companies that can offer value, discounts or packages are likely to drive revenue growth.

For the first time in a long time, consumers have compelling choices across value and growth, as sector performance is not restricted to just the mega-cap U.S. tech companies. However, given potential headwinds from tariffs, this warrants an active and selective approach to companies that have resilient demand, healthy margins and are adapting to the post-tariff environment.

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