A look at how the recent trend of earnings falling short of certain expectations has introduced a new element of complexity for income investors.
Author William Hines Investment Director, US Investment Grade and Global Investment Grade
Markets are all about expectations.
Take earnings. During the latest reporting season, 78% of the S&P 500 firms beat forecasts.1 This compares to the five- and 10-year averages of 77% and 74%, respectively.1 So, all good then? Not so fast. When we look at earnings growth expectations, the picture shifts. Markets had forecast average earnings growth of 8%.1 The number was closer to 3%.1 Meanwhile, the five- and 10-year averages were 8.6% and 6.8%, respectively.1
We also saw a slight deceleration of revenue growth, which was only 0.5% above estimates (vs. five- and 10-year averages of 2% and 1.4%, respectively).1 That said, we were always likely to see the number flatten after 15 consecutive quarters of growth.
So, where does that leave us? While the recent reporting season hasn't triggered a wholesale repricing of credit risk, it does signal a potential shift in the investment landscape.
Historically, periods of robust economic growth have often been accompanied by elevated corporate earnings expectations. Investors, eager to capitalize on this momentum, have bid up asset prices, including equities and credit. In such an environment, income-focused strategies have often thrived, as companies with strong earnings tend to offer higher yields.
The current landscape is evolving
This discrepancy between earnings expectations and reality has led to company-specific underperformance in equity and credit markets.
It's crucial to emphasize that we do not expect corporate profitability to nosedive. Instead, it represents a moderation of overly optimistic forecasts. Companies are still generating profits, and many continue to offer elevated yields and maintain strong credit profiles. However, this gap between expectations and outcomes has created volatility and uncertainty for investors.
How sustainable are current yields?
For income investors, this development raises two questions:
- How sustainable are current yields? While cuts remain relatively rare, the pressure on earnings growth could affect future increases.
- What’s the outlook for credit quality? The overall credit environment remains sound. That said, the potential for heightened financial stress among companies that consistently miss earnings estimates cannot be ignored.
We believe income investors may want to consider a more selective approach to navigate this evolving environment. Focusing on companies with resilient business models, strong balance sheets, and a history of maintaining higher yields can help mitigate risks. Additionally, diversifying across different asset classes and sectors can potentially provide some insulation against company-specific challenges.
Investing in a slowing economy
It's also essential to monitor credit spreads. While they have not widened significantly, signs of increasing credit risk should prompt a reassessment of portfolio allocations. High-quality bonds, such as those issued by governments and investment-grade corporations, we believe may offer a relatively safe haven during periods of market uncertainty. These bonds provide historically consistent yields and lower volatility compared to equities.
Against this backdrop, we favor high-quality investment-grade bonds, non-cyclical names, and maturity overweight in the intermediate part of the yield curve.
Final thoughts
The recent trend of earnings falling short of expectations has introduced a new element of complexity for income investors. For us, it underscores the importance of careful analysis and portfolio diversification.
While the latest earnings seasons may pause investors, we believe maintaining perspective is important. Economic conditions are dynamic, and earnings growth will reaccelerate at some point in the future. Moreover, income-oriented investing remains a viable strategy for long-term wealth creation.
1 "Earnings insight." FactSet, August 2024. https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_080924.pdf.
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