Q4 Earnings Preview: A Consequential Round of Reports

The new year has gotten off to a weak start for equity markets, dampening investor sentiment as hopes for an extended postelection rally fade. The Dow Jones Industrial Average has erased all of its gains since the November election, while the Russell 2000, often viewed as a key beneficiary of Donald Trump's second term, has tumbled 10% from its late-November highs. Broader indices like the S&P 500 and Dow Industrials are each down about 1% year-to-date, weighed down by soaring Treasury yields. The 10-year yield recently hit 4.772%, its highest level since late 2023, fueled by stronger-than-expected economic data, including last week's robust jobs report. This surge in yields has led to growing doubts about whether the Federal Reserve will cut interest rates this year, applying additional pressure on equities and raising the stakes for the upcoming Q4 earnings season.

As earnings season kicks into gear, analysts expect aggregate S&P 500 earnings to grow 11% year-over-year, with median constituent growth at 6%.This would mark the best Q4 gains since 2021 but would be down from the 14% witnessed in Q3.  Investors are pinning hopes on strong corporate earnings to offset the headwinds created by higher yields and elevated valuations, as the S&P 500 trades at 22 times forward earnings, above its 10-year average of 18.5. However, higher borrowing costs and the stronger dollar—products of rising yields—pose risks to profitability that investors will track closely this season. Additionally, earnings growth will need to extend beyond the tech-heavy names that powered last year's rally to provide broader market support. As Larry Adam, CIO of Raymond James, noted, "This fourth-quarter earnings season is probably one of the most consequential earnings seasons that we're going to see in a long time." The stakes are high, and investors will be watching closely for signs of resilience—or weakness—that could set the tone for 2025.

The Key Issues

This earnings season, investors will be closely monitoring three critical issues that could shape the earnings outlook for 2025. First, corporate sales growth remains a key focus against the backdrop of slowing nominal GDP growth and a strengthening U.S. dollar. With the dollar appreciating by 9% during 2024, including a 4% increase in the fourth quarter compared to the prior year, companies with significant international revenue exposure are expected to face headwinds from unfavorable currency translations. Approximately 30% of S&P 500 revenues are generated overseas, and historically, periods of dollar strength have led to fewer revenue beats. This trend could weigh heavily on goods-producing sectors, where volume growth may not fully offset the disinflationary pressure on prices. Conversely, services-oriented companies are showing some resilience, with analysts slightly raising estimates for this segment heading into the new year. 

The second major issue concerns how companies are adjusting to the policy uncertainties associated with the incoming Trump administration. Tariff proposals, changes in tax regulations, and heightened economic trade policy uncertainty are at the forefront of investor concerns. During the 3Q earnings season, management teams frequently discussed strategies for mitigating the potential impact of tariffs, including passing higher costs to consumers, stockpiling goods, and reconfiguring supply chains. These themes are expected to remain prominent this quarter, especially as companies face the prospect of elevated import activity and pressure on capital expenditures in early 2025. Investors will be keen to hear how companies plan to navigate these uncertainties, particularly given fears that higher tariff rates could reignite inflation and delay potential interest rate cuts.

Lastly, the sustainability of mega-cap tech stocks' earnings growth will be under the microscope. These companies, which were pivotal to last year's market gains, must demonstrate that their superior returns are enduring, especially as valuation pressures mount. The Magnificent Seven—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—are projected to drive a 22% jump in fourth-quarter earnings, far outpacing the 8.7% rise expected from the remaining 493 S&P 500 companies, according to FactSet. However, 2025 forecasts show a shift, with their earnings growth expected to decelerate to 18% from 33% in 2024, while the S&P 493's growth accelerates to 11% from just 3%. This narrowing gap could reduce the Magnificent Seven's dominance, as their recent outperformance has closely tracked their superior earnings growth. Still, the lower bar for 2025 estimates raises the potential for positive surprises in their fourth-quarter results to reignite their outperformance, keeping them central to the market's direction.

Analysts expect Information Technology and Communication Services to post the strongest earnings growth this season, at 18% and 19%, respectively. However, broadening earnings growth beyond the tech titans is critical for sustaining market momentum, particularly with sectors like Energy expected to see a 31% decline in profits due to lower oil prices. Investors will also pay close attention to consumer trends, as early reports suggest tighter spending from lower-income households, a dynamic that could weigh on retail and discretionary sectors. With high valuations and macroeconomic uncertainties looming, this earnings season will provide crucial insight into whether companies can navigate these challenges and maintain investor confidence in 2025.

What the Strong Dollar means for Earnings

The recent surge in the U.S. dollar, up nearly 10% since late September and 6% on a year-over-year basis, is likely to be a recurring theme during this earnings season, as companies address the impact of currency headwinds. While the stronger dollar is expected to lead to an increase in mentions of foreign exchange (FX) effects, its influence on index-level earnings is relatively limited. This is due to the S&P 500's overall foreign sales exposure being less than 30%, which results in a weak statistical relationship between the dollar's rate of change and aggregate EPS growth. Instead, dollar strength tends to have a more idiosyncratic effect, significantly impacting companies with high exposure to international revenues. Investors often penalize these firms for missing revenue estimates, though the impact is typically less severe if the shortfall is attributed to FX headwinds. For example, companies missing sales expectations on a constant currency basis underperformed the S&P 500 by 369 basis points on average the day after reporting results, compared to just 67 basis points for misses not related to currency factors.

The divergence between domestic- and internationally-focused companies is another critical consideration in periods of dollar strength. Historically, firms with domestic-facing revenues have outperformed their international counterparts when the dollar is strong. As earnings season progresses, investors are likely to focus on individual stock dynamics, creating a more robust stock-picking environment as the dispersion of EPS revisions widens. This environment is particularly favorable for companies in consumer services, where earnings revisions are strengthening in sectors like travel, leisure, media, and experiences, compared to weaker momentum in consumer goods, which continues to face tariff risks.

Lastly, the dollar's strength adds another layer of complexity to the broader market dynamics during a late-cycle economic extension. Small-cap stocks, with their more domestically-oriented revenue bases, may be less affected by dollar strength than large caps but remain vulnerable to higher interest rate sensitivity, as evidenced by their recent negative correlation with rising rates. This dual impact—greater rate sensitivity but lower exposure to FX headwinds—leaves the small versus large-cap debate balanced for now. Additionally, companies with high-quality balance sheets are expected to weather these pressures better, as they are less sensitive to both rate movements and dollar fluctuations. As such, the combination of dollar strength, interest rate dynamics, and varying earnings revisions underscores the importance of focusing on stock-specific opportunities during this earnings season.

Top Five Sectors (Most Exposed to the dollar):  

1. Semiconductors & Hardware Products (56%-60% of revenue from overseas markets): These industries are highly global, relying on international markets for significant revenue, making them sensitive to currency fluctuations. A strong dollar can erode profitability as overseas revenues translate into fewer dollars.  

2. Food & Beverage (45%): Multinational consumer goods companies in this space often generate a substantial portion of revenue from foreign markets, making dollar strength a headwind for reported earnings.  

3. Pharmaceuticals (45%): Pharma companies, given their global reach and large market shares in international markets, face similar currency risks that could impact profitability.  

4. Software & IT Services (44%): This sector's reliance on subscriptions and contracts from global clients makes it vulnerable to dollar strength reducing top-line growth.  

5. Autos (43%): Global automakers generate a considerable portion of sales in non-dollar currencies, creating exchange rate pressures on profitability.

Bottom Five Sectors (Least Exposed): 

1. Telecom Services (2% of revenue from overseas markets): Telecom companies are primarily domestic, with minimal reliance on foreign sales, making them largely insulated from currency fluctuations.  

2. Health Care Equipment (11%): This industry caters more to domestic markets or operates with limited international exposure, reducing dollar sensitivity.  

3. Real Estate (12%): Real estate investments and REITs are largely localized, and foreign sales make up a negligible part of their revenue streams.  

4. Banks & Diversified Financials (13%-14%): These sectors are relatively more U.S.-focused, with revenue primarily derived from domestic operations, making them less impacted by dollar strength.  

5. Transportation (17%): While global trade affects transportation indirectly, their revenue exposure to foreign currencies is comparatively lower than sectors like semiconductors or autos.

Overall, the most exposed sectors will need to carefully navigate the challenges of a strong dollar, while the least exposed sectors may see less immediate impact on their financial performance.

Conclusion

As the Q4 earnings season begins, the stakes are high for equity markets looking for direction amid a weak start to the year. The strength of the U.S. dollar, now up 10% since late September, is set to play a pivotal role in shaping corporate earnings narratives. Companies with high foreign revenue exposure, such as semiconductors, food and beverage, and pharmaceuticals, face significant headwinds from unfavorable currency translations, which could erode profitability. Meanwhile, domestically-focused sectors like telecom services, real estate, and financials are better positioned to weather dollar-related pressures. This divergence underscores the importance of stock-specific dynamics, as the broader S&P 500's foreign sales exposure of less than 30% suggests a limited impact on aggregate earnings.

Investors will also be closely monitoring how companies navigate broader macroeconomic and policy challenges. Tariff risks under the Trump administration, coupled with elevated interest rates and slowing GDP growth, add complexity to the earnings outlook for 2025. Mega-cap tech firms, which are expected to lead Q4 growth with a 22% earnings jump, will be under scrutiny to sustain their dominance as growth narrows in 2025. Additionally, the performance of consumer-oriented sectors will provide insights into shifting spending patterns and broader economic resilience. This earnings season is poised to offer critical insights into how companies plan to manage these headwinds, setting the tone for market performance in the year ahead.