Weekly Investment Commentary: Are “better than feared” earnings good enough?
Bottom line up top
- Thinner outlooks in the thick of earnings season. Last week’s mash-up of earnings reports, another 75 bps rate hike and a negative GDP release sparking debate over whether the U.S. is already in a recession was enough to make any investor’s head spin. “Spin” is also an apt description of how some headlines framed the week’s Q2 earnings results: “better than feared.” Fed Chair Jerome Powell’s tone was likewise perceived as “less hawkish than feared,” even though he didn’t change his inflation-fighting tune, and rates are all but certain to climb higher before year-end. Meanwhile, revenue and earnings beats (Figure 1), however welcome, are backward-looking. Of greater import is that guidance for the rest of 2022 and beyond has turned much more cautious, potentially pressuring future earnings estimates.
- A word or 10 to complement the numbers. All spin aside, earnings results from the second quarter have been objectively less favorable than in the recent past, with both the number of companies reporting positive earnings surprises and the magnitude of those beats below their five-year averages. What’s behind the downshift? Part of the answer can be found by analyzing the transcripts of earnings calls to tally the topics most frequently cited by management teams in explaining their company financials (Figure 2). This “word cloud” shows that while expected terms like “revenue” and “guidance” dominate, red flags like “inflation” and “headwinds” are also turning up in force.
“Guidance suggests corporate earnings could be in for a rough spell in the coming quarters.”
It’s not just about equities. While typically viewed as an equity market indicator, corporate earnings are also relevant to other asset classes, and have broader economic implications as well. Bond investors, for example, have a keen focus on downside risk, so we sought an earnings perspective from our senior fixed income portfolio managers given risks in the macro picture.
Among the key earnings trends they highlighted are post-COVID normalization (the continuing shift from goods to services), softer consumer spending and the impact of inflation on top-line results and margins. Sector selection is crucial, as is a focus on higher-quality credits as the macroeconomic backdrop possibly deteriorates.
Richard Cheng, who manages investment grade strategies, anticipates earnings will beat the lower end of forecasted ranges, but also foresees weaker guidance as tightening by global central banks hampers growth. His focus: the magnitude of margin compression. Scott Caraher, Head of Senior Loans, is assessing the micro and macro views of corporate fundamentals as well as the market’s reaction to determine how much of the bad news is already priced in. Our lead high yield portfolio manager, Kevin Lorenz, expects idiosyncratic risk to drive performance more than in the first half of the year, when rising rates and liquidity concerns outweighed other factors. Some of the weakest issuers, such as crypto companies, are most vulnerable to a slowing economy. In the second quarter, the high yield team materially shifted its focus from lower-quality (CCC) issues in favor of BBs.
Putting it all together: Amid heightened uncertainty around earnings for the remainder of 2022 and multiple macroeconomic headwinds, we suggest treading cautiously within equities. We view the recent ~10% bounce from the bear market low with some skepticism. At 17x forward earnings on the S&P 500 Index, investors aren’t being adequately compensated for risk, in our view. For this reason we continue to favor stocks of higher-quality companies with strong balance sheets. As for fixed income, we see opportunities in plus sectors, where spreads across high yield, senior loans and preferred securities remain well above long-term averages.
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