Third-Quarter Earnings Are Surprisingly Good

The U.S. Q3 earnings season reveals a broadening recovery, with a 16-year high in companies beating expectations and improving profitability for small-cap firms. Despite this wider growth, AI and the tech sector remain the primary drivers of earnings expansion across all market capitalizations. Notably, earnings for the largest S&P 500 companies are now rising faster than their stock prices, leading to a decline in their P/E multiples, while significant AI investment is also contributing substantially to GDP growth with long-term productivity benefits.

Analysis

The Q3 earnings season reveals a significant broadening of corporate profitability, with the proportion of U.S. companies beating analyst expectations reaching a 16-year high, according to Barclays Research. This recovery extends to small-cap companies, which are now showing signs of profit recovery after struggling with rising wages and interest rates. General Motors (GM) notably gained 15% post-earnings, partly due to faster-than-expected tariff bill reductions.

Despite the improving breadth, Artificial Intelligence (AI) and the broader tech sector remain the primary drivers of earnings growth and U.S. stock market outperformance across all market capitalizations. The tech sector contributes over half of the earnings growth in most S&P indexes, highlighting continued concentration. Notably, Goldman Sachs data indicates that for the top 10 S&P 500 companies, earnings are now rising faster than stock prices, leading to a decline in their price-earnings (P/E) multiples.

AI investment is significantly contributing to economic activity, with estimates suggesting it could account for 92% of GDP growth in H1 2025 and add more to GDP than U.S. consumer spending this year. Citi research indicates a ~$270 billion increase in AI equipment investment since 2023, representing 0.9% of GDP. While current AI investment is substantial, its potential to drive long-term productivity gains, potentially adding $3 trillion to the U.S. economy, suggests significant future economic benefits.

Key Decisions for Investors

• Investors should consider increasing exposure to small-cap equities given the nascent recovery in their profitability and broadening earnings beats.
• Maintain strategic overweight positions in AI-centric technology companies, recognizing their continued dominance in earnings growth and significant economic contribution, while monitoring P/E compression for potential value.
• Evaluate companies with strong AI investment strategies and infrastructure build-out, as these are poised to benefit from long-term productivity gains and substantial economic impact.
• Monitor tariff-related developments and company-specific mitigation strategies, as demonstrated by GM's positive earnings reaction.