Macro Pulse for May 17: Q1 Earnings Season: Outperformance Before Resilience is Truly Tested

Aside from profitability, capital expenditure activity showcases the extent of AI hyperscalers’ market dominance. Even in just the first four months of the year, capex across the major AI-related sectors – communications, consumer discretionary, and information technology itself, along with strong data center capex reflected in real estate sector numbers – has kept pace with 2025’s lights-out rate of physical investment. Importantly, the market’s perception of hyperscaler capex has shifted – from first celebrating capex in 2025; to concerns around return on investment in the first quarter of this year; and now to a view that capex is a proxy for hyperscalers’ market share and competitive advantage.

Euphoria today; sobering up tomorrow

Q1’s earnings strength shows minimal discernable impact from the energy shock. Strong expansion of earnings relative to revenues points to ongoing margin expansion across most sectors. This comes down to both cost discipline (which will become more difficult as input costs rise along with the energy shock) and strong operating leverage, through which companies with higher fixed costs benefit from economies of scale. While we can’t yet attribute market-level margin expansion to productivity gains of artificial intelligence application, many companies cited this impact in earnings calls this quarter.

Looking ahead, this resilience will be tested due to the conflict with Iran. We do not believe that forward earnings expectations capture the building second-order effects of the energy shock. April PPI shows a surge in input costs in the U.S., driven by energy costs, and with strong increases across both final demand goods and services. Mixed European earnings this quarter, which already reflect mounting cost pressures, also serve as a signal of headwinds to come.

While Q2 is likely to feature strong earnings among energy and utility providers, these costs may erode profit margins for energy-intensive industries, such as transportation and materials. Consumer discretionary may see some pressure, while staples may benefit from “trading down” behavior by consumers as they cope with higher energy prices. Finally, financials – in particular, smaller banks – may feel the crunch of an extended oil shock, with higher short rates pressuring net interest margins, a headwind for lending activity.

Portfolio strategy

There have been many moments in market history when earnings surged. But those surges have usually come as the economy was rebounding from recession, most recently post-pandemic and post-financial crisis. The first quarter’s rare mid-cycle earnings upside surprise helps explain why the market response has been so powerful.

Rising earnings expectations have been an important support for equity prices and have contained valuation concerns this year. The risk is that those expectations now embed a fair amount of optimism, particularly that the impacts of the Iran conflict will remain contained. If the earnings outlook begins to soften, or if geopolitical risks prove more persistent than expected, the same expectations that have supported the rally could become a source of fragility and drive renewed volatility.

Globally, we remain left with the U.S. as the “cleanest dirty shirt” in delivering the strongest earnings growth among developed market peers. But with U.S. exposure still concentrated in the tech theme, we continue to believe a neutral international exposure, adding business cycle and sector diversification, remains appropriate – and, increasingly, hedges an unexpected near-term resolution to the conflict in Iran.