Earnings updates and recent economic data have aligned to allow investors to leave for their summer holidays largely relaxed. There are several reasons for this sense of relative calm – rather than it signalling complacency, we believe it is warranted.
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Expected market volatility indices have continued to decline after the ‘Liberation Day’ spike. They are now near their lowest for the year and below long-run historical averages (see Exhibit 1).
US inflation showing little impact from tariffs
July’s US consumer price index (CPI) news assuaged investor worries over the impact of US import tariffs on shop prices. Despite some observers’ repeated assertion that consumers would pay for the Trump administration’s tariffs, there is little evidence of this so far.
We estimate the US government is on track to raise about $177 billion more in customs duties than it likely would have if tariff rates had not changed. Since ‘Liberation Day’, consensus estimates for corporate profits (both inside and outside the US) have fallen by about $152 billion, according to our calculations.
Companies have largely paid for the tariffs as they import the more expensive goods into the US. They have attempted to pass along the higher costs to consumers, but goods prices are rising at only a modestly faster pace than they were before tariffs were imposed.
The additional cost to consumers is perhaps at most an estimated $20 billion. While this seems large, monthly goods consumption totals $1.7 trillion, so the additional tariff costs are just 0.6% of goods consumption and even less of total consumption.
Companies will likely try to pass on more of the tariff costs to consumers, but they may also need to reckon with permanently lower margins until they are able to source US-produced inputs and goods rather than imports.
With the recent negative revisions to US non-farm payroll data and two sequential inflation releases that have met market expectations, the odds that the US Federal Reserve decides to cut benchmark rates in September appear to be rising.
Second-quarter earnings better than expected
The second quarter earnings season has gone better than expected, although not all the reported figures were good. Absolute year-on-year earnings growth rates for the US Russell Value index and Europe were poor, just not as bad as feared.
The headline 10.8% year-on-year earnings growth rate for the S&P 500 hides the fact that the earnings growth is coming primarily from NASDAQ companies, while the value part of this broad index saw little gain.
Profits for the technology sector have continued to be powered by artificial intelligence-related investments while being comparatively protected from the impact of import tariffs; the sector’s revenues are derived more from services than from goods.
Meanwhile, the value part of the S&P 500 has suffered due to the heavier weighting in the index of the oil, car and managed healthcare industries. Results from the first two industries have also weighed heavily on the overall result for European equities (see Exhibit 2).
Arguably more important than the absolute growth rates is the size of the earnings surprises. Typically, actual earnings come in 3-4% better than consensus forecasts as companies usually guide analyst estimates down prior to the earnings call and then somehow companies manage to beat those lowered expectations.
This season, surprises have ranged from 5-10%, suggesting that analyst forecasts of a significant negative hit to earnings due to tariffs were overly pessimistic.
This is not to suggest there was no impact — there were meaningful downward revisions to earnings forecasts after the ‘Liberation Day’ tariff announcements. But in the end, the impact was less than feared.
Purchasing managers’ indices and trade
The message from the purchasing managers’ indices was little different in July from the preceding months: the services sector is holding up, while manufacturing continues to struggle. The number of better-than-expected and worse-than-expected results was evenly balanced.
The latest PMI figures to arrive were for the eurozone, Italy and Spain (see Exhibit 3). The strong services sector readings for the two countries were offset by softer results for Germany and France, leaving the eurozone reading slightly below consensus at 51.2.
Perhaps the biggest surprise of the July PMI releases was the China Caixin Services Sector index. This jumped from 50.6 to 52.8 instead of declining to 50.4 as expected. This was also much better than the official services PMI reading of 50.1.
Similarly surprising was the strong rate at which the country’s imports and exports grew. This suggested US tariffs have yet to damp the country’s manufacturing vigour. Front-running of tariffs likely explains some of the increased activity. Exports to the US nonetheless fell by 22%, in line with the declines over the prior three months.
The reason total exports nonetheless rose is that shipments to Europe rose by 9%, while most of the drop in exports to the US was offset by more shipments to ASEAN countries. US imports from ASEAN increased by a commensurate amount (see Exhibit 4).
The outlook for Chinese manufacturing is nonetheless challenged: front-running is unlikely to continue at the same pace. Much will depend on the outcome of trade negotiations between the US and China. The US is aware of the trans-shipment phenomenon and will attempt to limit it, while Europe fears becoming the dumping ground for excess Chinese production.
