Macro: Geopolitics vs. Fundamentals

Renewed U.S.-Iran hostilities over the past week have cast fresh doubt on the ceasefire, pushing oil prices and bond yields higher while adding more uncertainty around the inflation outlook. The latest developments underscore that energy markets remain sensitive to the Middle East conflict, and we are mindful of the risk that further increases in oil prices could complicate the near-term path toward lower inflation.

Nevertheless, one consistent theme since March has been the economy’s ability to adapt more effectively than many expected. Moreover, we believe incentives and constraints on both sides suggest this latest flare-up can give way to another attempt at de-escalation. Although geopolitical headlines will continue to command attention in the interim, we expect market focus to increasingly shift towards corporate earnings as the reporting season begins. With earnings trends remaining favourable, corporate fundamentals can help offset geopolitical noise in shaping market direction.

Global Earnings: Looking for Breadth

As Q2 reporting season gets underway, the global earnings outlook remains constructive. Consensus estimates point to double-digit year-over-year profit growth for the MSCI All Country World Index, which would mark a fourth consecutive quarter of double-digit growth. Estimates have also edged higher lately, bringing the expected growth rate to its highest level since Q1 2022.

Regionally, Canada, the U.S., and international equities are expected to report earnings growth well above recent averages—though the sources of growth differ. The projected earnings gap between International Developed Markets (+17%) and Emerging Markets (+42%) is largely explained by their respective weights in the Info Tech sector (12% vs. 45%), underscoring the outsized role AI-related companies play in profit growth trends. By contrast, higher commodity prices have been a major driver behind upbeat expectations for Canadian earnings.

In the U.S., while earnings for AI-related industries are expected to outpace the broader market, the gap is forecast to narrow. Recent upward revisions have been concentrated in Energy and Info Tech, but ten of the eleven S&P 500 sectors are projected to report year-over-year growth. A broadening in earnings contribution, in our view, would represent a healthy development for equity markets, helping to diversify sources of return more widely across sectors, regions and themes.

Strong Fundamentals vs. A High Bar

Earnings expectations are high, but they are supported by a broadly resilient economic backdrop. Economic activity continues to expand, household spending has held up well thanks to a steady labour market, and corporate balance sheets generally remain in good shape.

Nevertheless, high earnings optimism inherently increases the likelihood that market reactions to the typical “meet or exceed expectations” may underwhelm. This dynamic could be particularly relevant for AI-related companies, where current elevated valuations likely already reflect expectations for sustained investment, rapid commercial adoption, and significant earnings growth far into the future.

Management commentary is therefore likely to play a more central role than the reported numbers. Investors will be looking for evidence that AI infrastructure demand remains durable, that AI-related capital spending is converting into revenue and profits, and that companies remain confident in their outlook for the coming quarters.

Admittedly, many of the lingering questions around AI remain difficult to evaluate. These include the scale and duration of AI infrastructure investment, the risk of disruption to existing business models, and the degree to which AI will improve productivity. As expectations evolve, markets are likely to experience periods of volatility as competing narratives prompt investors to reassess long-term assumptions.

Takeaway

We believe the path forward for markets is still positive, but we are also cognizant that investor sentiment is likely to remain more sensitive than usual due to shifting views on inflation, interest rates and AI investment durability. In our view, a measured approach of balancing long-term growth opportunities with diversified sources of returns across different asset classes can help shore up portfolio resilience during periods of uncertainty.

Should you have any questions, please feel free to reach out.

Beth Arseneau, FMA, CIM
Portfolio Manager
416-960-4592
beth.arseneau@rbc.com