The US Q3 earnings season is in full swing, producing strong results, with financials taking the lead. Strong advisory and trading revenues, coupled with solid net interest income has boosted bank earnings. Yet performance is unlikely to benefit to the same degree. The sector is expensive, and credit risks could spread.
This is reason enough to wait for a better entry point. The view also holds for the broader market. Recent weeks have been a reflection of the vulnerability of the US equity market. At record-high valuation multiples, it does not require much for a setback. Fundamentally, we would also caution against overestimating the potential earnings boost from solid Q3 reporting. More important for consensus data is the US dollar, which has recently turned from tailwind to headwind. We continue to see opportunities in a defensive allocation tilt and tactically prefer Swiss and European equities.Â
Q3 earnings off to a strong start
The US Q3 earnings season is off to a strong start. Out of the 17% of US companies which have reported so far, 74% have beaten pre-season expectations. The aggregate growth rate of reported EPS is tracking at 17.3%, while the blended EPS growth number – blended with consensus estimates – tracks at 7.4% YoY. This is well ahead of the 4.5% expected by consensus at the beginning of the season and puts the season on track for an EPS growth rate of around 10% YoY.
Financials benefit from boost
The sector which has dominated the first two weeks of reporting is financials. 90% of US banks which have reported their Q3 results managed to beat pre-season expectations. Financials’ earnings growth is tracking at 20% year-over-year, which is the highest growth rate among all US sectors, as it stands, and the highest EPS growth rate for financials since 2021. The key driver behind the acceleration in bank earnings growth has been the strong contribution from advisory revenues and trading fees. A pick-up in M&A deal volumes and rising equity markets have boosted investment banking earnings. Yet, more than that, net interest income also recorded a solid increase. This may have been the bigger surprise, given the fact that US yields dropped in Q3.
Regulatory easing to improve environment for banks
Banking regulation in the US has also shifted in favour of the sector. Recent reports suggest a substantial easing of required capital increases in the years ahead. The Fed has floated plans which would increase bank capital requirements by 3% to 7%, which is substantially below the levels floated in a proposal from 2024. This should help the sector to retain its profitability levels provided the cycle remains on track. Yet we would not upgrade the sector right now, given that valuations have recently touched a post-GFC high. The price-to-book ratio has touched 1.5x, a level which already implies a material improvement in profitability (RoE) in the quarters ahead. What adds to this slightly cautious view are recent hick-ups in the private credit space. The opaqueness of the space leaves banks in a vulnerable spot, mostly via their indirect relationship to the affected entities. If the issues in the private space were to spill over into public credit markets, banks would likely be the most affected sector. No other sector tends to underperform more than the banking sector when credit spreads rise.
Support for consensus earnings offset by USD headwinds
The strength of the earnings season should only provide limited support for consensus earnings expectations. More important is the dominant role of the US dollar. While the weakness of the US dollar in H1 guaranteed solid earnings upgrades over recent months, this effect is fading. The trade-weighted USD troughed in July and has slightly appreciated since. 1-month US earnings revisions tend to follow those FX moves, with the recent US dollar appreciation suggesting downgrades in the months ahead. These potential downgrades are meeting a market which is already trading at record-high multiples, making substantial further near-term upside unlikely.
Room for short term defensive outperformance
We stick to our defensive preferences against this market backdrop. The recent outperformance of defensives vs cyclicals, after cyclicals touched a record high, has a bit further to run. Cyclicals’ relative performance has substantially overshot vs the cyclical macro data. This has partly been driven by a widening AI trade, which has boosted industrials and other cyclical sectors, but also by the underperformance in sectors like health care, which should do better in the months ahead, as political risks have been sharply reduced.
Defensive preference and cautious on US index
Bottom-line, the point in the cycle we are currently at supports a more defensive and slightly cautious stance on the market. The earnings season is unlikely to change that. We would want to see the market internals, such as sector and style dynamics, adjust before turning more positive again. On the financials, more clarity on credit risks or more attractive valuations would be required to lean into the fairly solid medium-to-long-term earnings outlook. For the time being, our tactical preferences lie with defensive sectors and European equity markets.
By Wolf von Rotberg, equity strategist at J. Safra Sarasin Sustainable Asset ManagementÂ
