Investors look beyond earnings growth

Strong earnings have supported markets, but higher rates and inflation are raising the bar for capital efficiency, making free cash flow an increasingly important measure of financial health.

Are businesses still profitable in a higher-cost, higher-rate world? Earnings season suggests that they are, but investors may need to look beyond EPS beats. While operating margins, which reflect the profitability of a company's core business, have remained broadly resilient, free cash flow margins are beginning to diverge across sectors. Since free cash flow (FCF) ultimately reflects the cash available to repay debt, return capital to shareholders, or reinvest in the business, it may provide a more complete picture of financial health. As AI-related capital spending accelerates, FCF margins could become an increasingly important measure of whether strong earnings growth is translating into sustainable shareholder value, especially in an environment marked by persistent inflation and higher capital costs.

Weekly Highlights 

Rising rates, higher standards

Rising rates, inflation, and geopolitical uncertainty would normally challenge equities, but the market has remained resilient through rotation rather than broad weakness. Leadership has broadened beyond AI-linked and semiconductor names, with more cyclical sectors such as Energy and Financials assuming a greater share of market leadership. Higher yields may be contributing to this shift by pressuring long-duration growth assets whose valuations rely heavily on future cash flows.

In an earlier edition, we noted that strong earnings growth had largely allowed technology companies to look through a higher-rate environment. Today, that relationship appears to be shifting. Earnings expectations remain robust, but investors are placing greater weight on tighter financial conditions and whether future growth can justify demanding valuations, particularly as free cash flow comes under pressure and the return on today's investments remains largely prospective.

Interestingly, fixed income markets appear to be sending a similar message. Spreads have remained relatively contained at the broad index level, suggesting credit markets are not pricing in a meaningful deterioration in economic or corporate fundamentals. However, spreads on hyperscaler debt have drifted wider as investors absorb record levels of issuance. That theme is also showing up in credit default swap markets, where CDS spreads for hyperscalers such as Alphabet, Amazon, and Meta have recently reached record levels.

Investors demand more than just earning’s growth. The chart below illustrates how FCF margins have evolved across hyperscalers over the past decade. While the trend has varied by company, this year free cash flow margins have come under pressure as AI-related capital expenditures accelerated. Apple stands out as the exception, having maintained and recently improved its cash flow generation.

Alphabet's Q2 earnings results illustrate the debate between earnings and cash flow. Revenue growth remained robust, Google Cloud revenue surged, operating income expanded, and earnings largely exceeded expectations. Yet investors focused less on the strength of the quarter and more on management's decision to raise capital expenditure guidance. Alphabet shares fell roughly 7% in the trading session following the earnings release.

Microsoft's results offered a different perspective. The company delivered strong top-line growth, Azure revenue accelerated, and management highlighted continued adoption of its AI offerings, including more than 30 million paid Copilot seats. The quarter provided some of the clearest evidence to date that AI investments are beginning to translate into meaningful revenue growth.

Meta's results fell somewhere in between. Revenue growth exceeded expectations and advertising fundamentals remained healthy, but investors continue to wrestle with the cost of the company's AI ambitions. Operating margins compressed meaningfully from a year ago as expenses accelerated, while free cash flow remained limited despite strong revenue growth. Unlike Alphabet, Meta did not raise capital expenditure guidance, but the quarter nevertheless highlighted the growing tension between investing aggressively for future growth and preserving profitability.

Financials offer a particularly revealing point of comparison. The chart below illustrates how free cash flow margins have evolved among some of the largest banks in the S&P 500.

Bank’s free cash flow margins have historically been more volatile than those of the hyperscalers, reflecting the unique nature of financial institutions' balance sheets and capital management practices. However, the group generally maintains higher free cash flow margins than many large technology companies investing heavily in AI infrastructure, and those margins have improved this year. The contrast highlights a key theme of the current market rotation: investors are rewarding sectors/industries that can demonstrate strong earnings growth alongside improving cash generation (ex. Materials +13% YTD, Industrials +14% YTD, Banks +8% YTD).

Despite ongoing questions surrounding rates and the economic outlook, many banks have reported strong results. With all banks having reported, the group delivered earnings growth of approximately 33%, exceeding expectations by roughly 20%. Standout performers included Citigroup, JPMorgan Chase, Citizens Financial, Huntington Bancshares, and Truist Financial, each posting earnings growth of more than 30% year over year. Importantly, 84% of banks reported positive earnings surprises, helping lift the Financials sector's expected earnings growth rate to roughly 20%.

Several common themes emerged across the results. First, capital markets activity remained exceptionally strong. Many banks pointed to one of the healthiest dealmaking environments in years, as investment banking and trading activity benefited from robust IPO issuance, elevated M&A activity, healthy equity capital raising, and increased market volatility. Second, the credit environment remains healthy. Management teams consistently pointed to resilient consumers, stable credit quality, and ongoing spending activity, helping support solid loan performance and improving business conditions. As a result, there has been little evidence of the credit deterioration that would typically accompany concerns about an economic slowdown. Together, these trends drove fee income meaningfully higher and provided a significant tailwind to earnings.

With roughly half of the S&P 500 having reported, earnings season has generally exceeded expectations, pushing quarterly growth estimates higher. Yet market reactions suggest investors are becoming increasingly selective about what constitutes a positive result. While the economy remains resilient and AI demand continues to expand, higher rates and persistent inflation are raising an already high bar for capital efficiency.

Source: State Street Investment Management, FactSet, S&P. Data as of 7/29/2026 unless otherwise stated. Total returns in USD unless otherwise stated. The performance data quoted represents past performance. Past performance does not guarantee future results. Investing involves risk, including the risk of loss of principal.