Nvidia's Earnings Report to Test Tech Sector's Health, Market Sentiment

Investors are closely watching Nvidia's second-quarter earnings report, scheduled for release after the U.S. market closes on Wednesday. This report is seen as potentially more influential than the dovish signals from the Federal Reserve Chairman last week, which hinted at a potential rate cut. The significance of Nvidia's earnings report lies in its ability to provide insights into the tech sector's health and future prospects, which are crucial for maintaining the recent upward trend in U.S. equities.

Last Friday, U.S. stocks surged, with the Dow Jones Industrial Average closing at its first new high since December 2022. This rally was driven by the Federal Reserve Chairman's suggestion of a possible rate cut in September. Small-cap stocks saw their best single-day performance since May, and the S&P 500 index achieved three consecutive weeks of gains. However, on Monday, the market gave back a significant portion of its gains, as investors began to scrutinize the underlying reasons for the dovish stance.

Lower interest rates typically support the stock market by reducing the discount rate for future cash flows. However, if the rate cut is due to economic slowdown, corporate earnings could deteriorate. Conversely, if the rate cut sparks inflation, the real value of future cash flows could be eroded. The Federal Reserve Chairman warned of a cooling job market and visible inflation risks from tariffs, suggesting both scenarios are at play.

The bond market reflected these concerns. On Monday, the spread between 2-year and 10-year U.S. Treasury yields widened to its highest level since 2021, with short-term yields falling faster than long-term yields. This indicates that while the market expects the Federal Reserve to cut rates, it also anticipates persistent inflation and stagnant economic growth.

RBC Capital Markets' U.S. equity strategist highlighted that weak growth could challenge the tech giants that have driven the U.S. stock market this year. The market needs to see a significant upward revision in GDP expectations before analysts raise their earnings forecasts for these tech giants. This could pose a challenge to further gains in the U.S. stock market, particularly for large-cap growth and tech stocks.

Against this backdrop, Nvidia's second-quarter earnings report, due out on Wednesday after the U.S. market closes, is of particular interest. As a leader in AI chip technology, Nvidia is at the heart of the tech giant rally, with approximately 40% of its revenue coming from major tech companies. Nvidia's market capitalization is around 4.3 trillion dollars, making up about 8% of the S&P 500 index. According to Synovus analyst, about 60% of these tech giants' capital expenditures are directed towards AI, making Nvidia's sales outlook a critical test of the market's most important narrative.

The six largest tech companies by market capitalization in the U.S. account for about 34% of the S&P 500 index. This means that Nvidia's performance could have a more significant impact than the rate cut expectations. Although the Federal Reserve will have employment and inflation data before its September meeting, Nvidia's outlook could be more decisive.

While AI trading is undoubtedly a positive factor for the U.S. stock market, RBC's strategist noted that last week, investors sold off tech stocks as the AI theme driving the giants' rally came under intense scrutiny. Nvidia's stock price has increased by over 1 trillion dollars in market value over the past 12 months, with a year-to-date gain of nearly 30%. Its valuation is already quite high. Standard Chartered Bank's global investment strategist warned that Nvidia's stock price has "almost no room for error" ahead of its earnings report on Wednesday.

He cautioned that while Nvidia holds a dominant position, its "Achilles' heel" is that competitors or regulators could quickly change the game. If growth slows or profit margins fall short of expectations, the downside risk could be severe. Investors will be closely monitoring Nvidia's earnings report for any signs of weakness or caution in its outlook, which could dampen market sentiment and lead to a pullback in U.S. equities.