Commentary by Colleen Cunniffe, head of global credit research, Vanguard, and Kunal Mehta, head of fixed income specialist team, Vanguard, Europe.
Bond markets are becoming increasingly demanding of bond issuers as global financial conditions tighten, as the rapid sell-off in UK government bonds following the government’s ‘mini’ budget in September illustrated.
Now, with corporate America at the midway point of the third-quarter earnings season, bond investors are on heightened alert for indications of how companies are faring in the new era of rising interest rates and and challenged economic outlooks.
Expectations were already low before Q3 results reporting began, with Q3 consensus earnings estimates for S&P 500 companies declining on average by 3.5%1 and results so far have broadly matched these subdued outlooks. By the end of October, roughly half of companies had reported, and while 70% of them beat expectations, broad earnings growth was down -4% year-over-year.
As core aspects of the US economy such as consumer spending and housing have weakened materially over the course of 2022, this has been reflected in corporate results. For example, the materials, discretionary consumer (particularly online retail) and communications and media sectors have seen the largest contractions in earnings power year-over-year.
Many of these companies have taken a hit to both their top and bottom lines as high costs from more persistent inflation have combined with weaker end-market demand, which we believe will continue to weigh on their profit margins over the coming quarters.
Big tech names such as Amazon, Microsoft and Meta have also disappointed as Q3 results revealed decelerating sales growth and weaker forward growth expectations. Equity markets have already delivered their verdict on the tech slowdown: the weight of the technology sector in the S&P 500 has declined from 46% on a market-capitalisation-adjusted basis at the start of the year to around 37% at the end of October2.
However, it hasn’t all been bad news. On the back of a rise in the price of oil over the past year, the US energy sector has perhaps unsurprisingly witnessed a rise in earnings power. Companies in the real estate investment trust (REIT) and industrials sectors also experienced earnings growth in Q3.
In Europe, where Q3 results lag those in the US, initial indications show that companies have displayed strong performance despite the difficult market context. Most corporates moderately beat analyst expectations, while the energy sector again saw stellar earnings growth. But while European company fundamentals have held up well so far, credit metrics remain at risk of being trumped by the deteriorating macroeconomic backdrop and geopolitical risks.
In Asia-Pacific, corporate Australia has been impacted by the Reserve Bank of Australia’s fastest rate tightening cycle since 1994, with many boards delaying or decelerating investment decisions and projects – the Australian property sector has been especially hard hit. That said, Australian balance sheets remain broadly robust across sectors, with many companies passing on higher raw material and other input costs to their customers.
The financial and economic headwinds facing corporate issuers are one obvious cause of the slowdown in earnings. Alongside weakening consumer confidence, management sentiment is waning, which is reflected in slowing corporate expenditure.
But there are other trends we have observed which are impacting results. For one, the US labour market remains tight and—should wage pressures remain—this would be a clear risk to profit margins going forward. That said, there is increasing talk of hiring freezes in Q3 earnings updates.
The strength of the US dollar is also a distinct earnings headwind for those US companies with significant foreign revenue exposure. We estimate that around 30% of S&P 500 revenues are domiciled outside the US, with technology—where foreign revenue exposure is approximately 60%—the most exposed sector. We expect that US dollar strengthening could account for a 3-5% drop in forward earnings guidance in 20223.
On the upside, while more persistent inflation is an ongoing challenge for corporates, pricing power remains robust across the consumer staples and services sectors. For example, PepsiCo and Unilever have recently raised average prices to more than compensate for volume shortfalls.
The latest earnings season highlights some of the hurdles facing credit issuers, and there are likely further perils ahead. While corporate bond spreads have recently widened, there is potential for further spread expansion as economic growth slows and a recession bites – although higher yields will ultimately provide better shock absorption against any market turbulence.
Within investment-grade bonds, many issuers have been more disciplined in their financing than in prior cycles and have maintained strong balance sheets. As a result, outside of a large market downturn, we feel a broad wave of ratings downgrades is unlikely. We feel that the best approach for active investors in this environment from a risk-reward perspective is to focus on a core allocation to higher-quality, defensive credits that are less sensitive to a weakening global economy.
Among lower-quality bonds, the challenging market backdrop is creating more dispersion and giving rise to more attractive entry points, provided, of course, that they are selected on an individual basis and with care. In high-yield debt, our preference is for the higher-quality tranches of the market, with security selection likely to be the most important driver of performance in the coming quarters.
Written in collaboration with Maria Colangelo, Vanguard senior credit analyst and co-head of the global industrials team, Alicia Low, senior analyst and manager, global credit research, and Maija Sankauskaite, investment analyst, global credit research.
1 Source: Bloomberg as at 31 October 2022.
2 Source: Bloomberg, 1 January 2022 to 31 October 2022.
3 Source: Vanguard.
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