Without doubt, second-quarter earnings season is taking on greater significance than usual as markets seek fresh and ever greater evidence that the artificial intelligence (AI) supercycle is continuing to help boost corporate profits, in turn propelling equity markets higher.
What’s striking is that investors seem to have all but shut out the recent re-escalation in the Middle East conflict, lingering though falling inflationary pressures—headline and core U.S. consumer price index inflation fell in June to 3.5% (from 4.2% in May) and 2.6% (from 2.9%), respectively—and monetary policy uncertainty under the new Federal Reserve chair, choosing instead to focus on the strength of corporate earnings.
The numbers explain why the stakes feel so high. S&P 500 earnings are projected to rise more than 20% year-over-year, the fastest pace in roughly four years, against a median company-level estimate of just 8%. That gap is heavily skewed by a small group of mega-cap technology and memory-chip names.
This matters because it shows how narrow the market’s margin for error has become. If the headline growth rate depends on a handful of companies delivering exceptional results again, any weakness among them, or any sign the broader index can’t close that gap, risks unsettling a rally built entirely on earnings rather than rising valuations.
Indeed, while many investors acknowledge the case for an equities pullback, they are not acting on it at scale. The seasonal rebalancing among institutional investors, which typically weighs on stocks this time of year, has not materialized as broadly as we would expect, perhaps pointing to how much conviction is riding on earnings alone.
Good Isn't Good Enough
That concentration cuts both ways, and the risk was on full display last week. The big U.S. banks kicked off earnings season with strong results yet barely moved the market. In contrast, IBM’s warning that revenue and earnings would miss expectations did the opposite: the technology and consulting company’s shares fell nearly 25%, the largest single-day drop on record.
This contrast tells the real story. Strong results are simply expected; a single disappointing one can dominate sentiment and market narrative. In our view, with expectations climbing almost daily into this reporting season, the market has settled into an uncomfortable asymmetry: merely strong numbers may go unrewarded, while any miss gets punished severely. It is, therefore, shaping up to be a difficult quarter to have a difficult quarter.
Why Breadth Is the Real Test
This asymmetry raises the bar on breadth, not just strength. The hyperscaler and memory-chip names that drove the second quarter are already showing cracks, with choppy trading in memory stocks over recent weeks. If that continues, we could see capital rotating back to the Magnificent 7 mega-cap tech companies, the very concentration this earnings season needs to move beyond.
Indeed, the market cannot expect the same handful of names to carry performance. For the earnings story to remain a credible foundation for the second half, momentum needs to broaden well beyond the hyperscalers and the other AI-related sectors such as hardware and data centers into other parts of the market entirely. Absent that, even solid headline growth may not be enough to sustain conviction.
Importantly, earnings are not the only variable in play. Even if results hold up through the current reporting cycle, markets will soon face a historically volatile eight-week period where market sensitivity to comments from central bankers is high. Recent comments from Fed officials Lisa Cook, Christopher Waller and John Williams have already flagged policy risk, and financial conditions are incrementally tighter. The earnings narrative may carry markets through July, only for a shift in Fed tone to become the dominant risk heading into the second half of the year.
What This Means for Positioning
As we highlighted in our most recent Asset Allocation Outlook, Staying Pro-Risk in a Broadening AI Cycle, we remain overweight global equities and U.S. large caps, with a strengthening, broadening earnings story supporting that view.
Given this, we believe it’s important to stay invested but be selective. Core exposure to U.S. large caps still makes sense, but we favor rotating into sectors positioned to benefit from broadening earnings strength, industrials, utilities and infrastructure tied to AI-related capex rather than concentrating further on last quarter’s winners.
At the same time, valuations, near 20x forward earnings, still look reasonable given the strength of the underlying earnings base. But this is a market with little room for disappointment, resting on a foundation that needs more than earnings holding up. It needs that strength to spread beyond the handful of names already showing signs of fatigue. Good may no longer be good enough.
This is the quarter where the AI story, and the rally built on it, stops being told and starts being proven.
What to Watch For
Monday 07/20:
- Germany Producer Price Index
Tuesday 07/21:
- Eurozone ZEW Economic Sentiment
Wednesday 07/22:
- U.K. Consumer Price Index
Thursday 07/23:
- Eurozone ECB Interest Rate Decision
- U.S. Initial Jobless Claims
Friday 07/24:
- U.S. Manufacturing Purchasing Managers’ Index
- U.S. Services Purchasing Managers’ Index
- U.S. New Home Sales