Key Highlights

• S&P 500 Q2 earnings expected to beat 5% forecast, potentially reaching 9%
• AI has reemerged as a U.S. productivity driver despite high real rates and uncertainty
• The valuation gap between US tech and global markets remains significant with EM split, DM rising

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Role of tech investments limiting inflation expectations in Q2 earnings

EXHIBIT #1: U.S. CPI VS. CORRELATION OF S&P 500 EARNINGS AND U.S. TOTAL FACTOR PRODUCTIVITY

_{Source: BNY, IMF, BLS}

Q2 S&P 500 earnings are expected to easily beat expectations of 5% EPS, with 9% or higher likely, according to FactSet. The key question is: Will this time be different? Estimated earnings have come in above forecasts in 37 out of the past 40 quarters, with just three quarters coming in below expectations: Q1 2020 (at the start of the Covid pandemic), Q3 2022 and Q4 2022 (when the FOMC surprised with more aggressive tightening). The hope that things will be “normal” now is driving markets to rotate out of international stocks and back into the U.S. market. Supporting this view are expectations of a Fed rate cut, plentiful cash in money markets, continuing investments in AI, and the fact that U.S. consumer spending remains stable. However, there are still risks, including how tariff policy is implemented and the impact in Q3. AI has returned as a secular theme, driving productivity hopes despite ongoing pressure from high real rates and continued uncertainty, with momentum exhaustion in shares highlighted by financials this week. The underlying health of the U.S. economy remains the key driver of equities, with analysts discounting financial results linked to trading revenue from Q2 volatility.

Our take 

Over the long term, U.S. total factor productivity has correlated with S&P 500 earnings by a factor of 0.35%. The highest correlation on record occurred during the first tech boom from 1990–2005, when it was 0.6%, while the lowest (0%) came both during the stagflation of the 1970s and the Covid-19 pandemic. The question now is, which way will the correlation move with risk-taking bifurcating in the U.S. around AI and banks. Possible Fed rate cuts are important for both of these themes, and both require stable inflation. Currently, holdings of the U.S. tech sector are 9% above their 10-year average, while banks are 7% over their 10-year average. As the Q2 earnings season begins in earnest, there are concerns about valuations and whether Q2 will represent the peak for banks and IT.

Forward look 

Broader demand for AI investments needs to be clear in earnings reports to support outperformance. Investors need to believe in productivity if U.S. earnings are to remain strong. The “hope trade” is based on AI acting as a key driver of cost reductions and private-sector output improvements. The downside risks revolve around the disruption to global trade from tariffs, which could force another rethink of supply chains. The experience of the Covid pandemic, when supply chains were disrupted and productivity collapsed and then recovered, shows the problem of noise during unusual economic times. Like the Fed, investors need to see CPI return to 2% to allow current productivity and earnings expectations to continue.

The role of U.S. leadership in big tech vs. rest of world a key test for July

EXHIBIT #2: INTERNATIONAL LARGE CAP VS. MAGNIFICENT 7 INDEXS 

_{Source: BNY, Bloomberg}

EXHIBIT #3: INTERNATIONAL LARGE CAP VS. IFLOW HOLDINGS 

_{Source: BNY, Bloomberg}

(The BNY large cap index includes: TAQA, Al Raji Bank, ASML, Boyd Gaming, HSBC, ICBC, LVMH, Mercado Libre, Novo Nordisk, Petrobras, Reliance, Roche, Samsung, SAP, Saudi Aramco, Shell, Siemens, TSMC, Tencent and Toyota.)

Our take 

There are 125 companies in the S&P 500 index with a market cap over $100bn, and the average index market cap is $105bn – highlighting the skew of the top 10 shares, which includes the “Magnificent 7.” Duration and valuation factors, which we discussed last month, stand out as we head into Q2 earnings reporting season for tech companies next week. The push to diversify stocks began in Q1 2025, but the key pivot moment was the bounce following the tariff pause on April 8, highlighted by the rally in EU industrials, Asian tech names, and banks in both regions. Outside the U.S., there are 155 companies with a market cap of $100bn or more. The three largest are outside of Europe: Saudi Aramco, TSMC in Taiwan and Tencent in China. The push to own the top 20 international (non-U.S.) companies started in October 2023 and peaked in the summer of 2024. “Liberation Day” volatility in April was significant to our client flows, but markets bounced back and are now close to their 2024 highs.

Forward look 

Overheld positions in EU industrials and Asian tech are showing up in BNY’s international large cap index (see Exhibit #4). The selling since July reflects ongoing tariff concerns, lower global demand, margin pressures and the pressure from investors to rotate risk beyond momentum factors. The break in this index will be a key part of the summer trading environment. The valuation stretch of U.S. tech vs. the rest of the world is not going to go away quietly. The implications for other asset classes are important and U.S. exceptionalism will link back to how much USD hedging remains against FOMC rate cut plans for the rest of the year.

EM vs. DM split shows up in growth forecasts, but demographics are not destiny

EXHIBIT #4: G20 FORECASTS FOR 2030 POPULATION GROWTH VS. GDP GROWTH

_{Source: BNY, OECD, UN}

Our take 

Demographics are not destiny. However, the focus on growth and investment is connected to where the biggest demand shows up. The risks for investors depend on how AI productivity drives growth away from the role of population changes, with Asia and Europe standing out. This is at odds with the iFlow data, which shows a mix of holdings in stocks in EM vs. DM nations. EM equities should be the offset for more investors differentiated by their investments in tech and other tools to push productivity. In a report last month, the IMF highlighted this balancing act. Globally, fertility rates have fallen from an average of 5 births per woman in 1950 to 2.24 today, and rates are projected to dip below the 2.1 replacement mark by around 2050. This trend underpins forecasts for eventual depopulation, with the United Nations expecting the global population to top out at 10.3 billion in 2084. Thirty-eight nations are predicted to contract over the coming quarter century, up from 21 in the past 25 years, including China’s decline of 155.8 million, Japan’s fall of 18 million, and South Korea’s drop of 6.5 million. Africa’s fertility rates are above 4 and the continent should see its share of world population rise from 19% in 2025 to 26% by 2050, while immigration has helped six of the 21 sub-replacement fertility countries avoid shrinkage.

Forward look 

The willingness of investors to diversify globally remains a key question for Q3. When it comes to the next five years, growth and inflation will be revolve around immigration and birth rates. For investors, lower labor force growth may weigh on economic output, innovation and global demand, but resources freed from housing and childcare could shift into research and technology. Policymakers in low-fertility regions are exploring family-friendly policies, tax breaks, parental leave, and subsidized childcare, along with immigration reforms, to replenish workforces. These choices may be key to lifting some nations back above the regression line and attracting capital regardless of demographics. 

Raising retirement ages and improving education access can mitigate labor shortages, and robust investments in health can enable individuals to remain productive longer. For equities, the balance of savings and bond yields shows up in government pension burdens. Concurrently, automation and artificial intelligence may alleviate workforce constraints but also reshape job structures and social systems, adding to difficult political choices.

Bottom line

The numbers will speak for themselves in the weeks ahead as investors are positioned for good news and expect Q2 earnings that are better than forecast. A rotation linked to growth and value could surprise in August. The rest of the world is a significant part of the 2025 asset flow narrative, as current sentiment favors a rotation from international markets back to U.S. equities, supported by anticipated September rate cuts, abundant money market liquidity, sustained AI capital expenditures and stable U.S. consumer spending. Should any of these factors prove false, volatility increases, and global sentiment could turn lower. The correlation between U.S. total factor productivity and S&P 500 earnings (0.35% over the long term) underpins the current bifurcated market, with U.S. IT sector holdings 9% above their 10-year average while banks stand at 7%. However, tariff implementation remains a significant risk factor for consumer prices and corporate performance, alongside valuation concerns as Q2 potentially represents peak earnings for both the banking and technology sectors. The top 20 international large-cap index has experienced selling pressure since July amid tariff concerns, weakening global demand and margin compression, highlighting the valuation disparity between U.S. tech and global counterparts. Whether this continues will determine if we return to U.S. exceptionalism phrases to describe the summer of 2025.

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