Small Caps Lead Q2 Earnings Surge

IN THIS WEEK’S NEWSLETTER:

📊 Key Points From Nvidia Results
📈 In Line PCE Inflation With Strong GDP Growth
💡 Q2 Earnings Recap – Small Cap Outperformance
🏦 Required Banking Reserve Level Estimates
🤖 Alibaba Enters AI Race
🪙 More Alt-Coin ETFs

QUOTE OF THE WEEK:

“They're (Hyperscalers) spending hundreds of billions of dollars a year in CapEx. And these companies are not idiots. They're not spending this money with no visibility for a return or profitability. I think we're already starting to see adoption and returns on AI. And you have to remember also for some of these guys, it's also existential, right? The idea is if we don't continue to invest in this, the world is going this way. Like, we may be out of business if we don't. And so I think they keep spending.” - Stacy Rasgon, Bernstein semiconductor analyst

KEY US ECONOMIC EVENTS NEXT WEEK:

MARKET CLOSE:

WEEKLY MARKET WRAP:

CURATED INSIGHTS & ANALYSIS:

• Fed’s ON RRP Facility Balance Near Zero:
  
  The Fed’s overnight reverse repo facility, once absorbing more than $2 trillion a night, has now dropped to zero. That facility served as a pressure valve for excess cash in the system. Without it, every dollar of the Fed’s balance sheet reduction would flow directly from bank reserves, which currently stand at roughly $3.3 trillion.
  

  

  
  Reserves are the cash balances that allow the financial system to function smoothly, and their decline matters far more than the headline size of the Fed’s $6.7 trillion balance sheet.

  Quantitative tightening is reducing the balance sheet by about $40 billion a month. At this pace, reserves could decline to around $2.9 trillion by early 2026. Importantly, this is still well above the approximately $1.4 trillion level at which stress emerged in 2019; however, we need to adjust this number to today’s terms.

  Let’s estimate what the reserve level should be to avoid a 2019-like panic when the overnight repo rate spikes to 8-10%. Below are the three possible estimates -
  

  • GDP Anchor: As suggested by Fed Governor Christopher Waller, who noted that reserves below roughly 8% of GDP — about $2.2 trillion in today’s economy — could be problematic. By that measure, the current system still has a cushion of more than $1 trillion. The Fed also has stronger tools today, including the Standing Repo Facility, to smooth temporary strains.

  • Fed Balance Sheet Comparison: If we compare it to the Fed’s balance sheet in 2019, the $1.4 trillion reserve amount, plus the ON RRP balance, was ~40% of the Fed's balance sheet. With the Fed’s balance sheet ≈ $6.7T, the 2019-equivalent reserve floor (ON RRP is ~0 today) is: 0.40 × $6.7T ≈ $2.7 T. If the Fed’s balance sheet edges down to ~$6.2T (a common 2026 waypoint), the 40% floor becomes ~$2.5T.

  • Banking System Size Anchor: Reserves fell to approximately $1.4 trillion, against a banking system with roughly $17 trillion in assets. With assets now closer to $25 trillion, the equivalent reserve floor would be nearer to $2 trillion. Beyond scaling for the size of the banking system, it is prudent to allow a wider buffer today. Treasury issuance is larger, and the Treasury General Account is more volatile, resulting in greater swings in reserves.

    

    Primal Thesis

  Conclusion: Based on these estimates, it appears that reserves remain ample for now; however, repo spreads, SOFR relative to IORB, and usage of the Standing Repo Facility will indicate whether conditions are shifting from ample to scarce. I think it will be close to accurate to say that banking reserves falling below the ~$2.5 trillion will be problematic. Currently, reserves are at $3.3 trillion, providing a cushion of approximately $800 billion, which can allow the Fed to continue tightening for some time into 2026.
  
  

• Nvidia Results:
  Below are the essential points from the Nvidia conference call. I am not including actual results, which I covered in the earnings update.

  • AI infrastructure spending is projected to reach $3–4 trillion by the end of the decade.

  • Cloud and enterprise CapEx on data centers and compute set to reach $600 billion this year, nearly doubling in 2 years.

  • The top 4 hyperscalers alone have doubled their CapEx to $600 billion annually; broader enterprise and global CSP buildouts add further upside.

  • The U.S. accounts for ~60% of global computing; in the long term, AI adoption is expected to scale with GDP.

  • NVIDIA software advances and the developer ecosystem have doubled Blackwell performance since launch.

  • China's AI market is estimated to be worth $50 billion this year, with a potential annual growth rate of ~50%.

  • China hosts ~50% of global AI researchers and leads in open-source models, making market access strategically important.

  • Q3 outlook excludes H20 amid geopolitical issues; potential $2–5 billion revenue if resolved.
    
    

• Small Cap Outperformance:
  As I do every quarter, check below the quarter-over-quarter comparison of the earnings. This comparison illustrates how this quarter's earnings compare to those of the previous quarter, when a similar number of companies reported in both the S&P 500 and the Russell 2000 index during the earnings season. The most notable development this quarter is the sharp growth reported by small caps compared to the previous quarter. In fact, this is the first time I have noted such growth by small caps since I am writing this newsletter. This explains why the Russell 2000 surged 7.5% in August—more than twice the Dow’s gain and nearly triple the S&P 500’s.
  

  

  Primal Thesis

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This newsletter's content is for informational and educational purposes only and should not be considered trading or investment recommendations. All the opinions in this newsletter are personal and do not belong to any organization.