Where do fixed income investors go from here?
Earnings season is now in full swing, and it has undoubtedly been eventful. During the first quarter, companies have had to navigate multiple obstacles, including surging commodity prices, hawkish central bank policies, a Russian invasion, further supply chain disruptions caused by lockdowns in China, and dwindling consumer confidence. It is perhaps surprising, then, that aggregated numbers remain, on balance, positive and close to normal levels.
For example, with close to 75% of S&P 500 constituents’ results already posted, a more than respectable 81% have beaten earnings estimates, better than Q4-2021 and the historical average. Pleasingly, margins actually expanded in Q1, resolving one of the major uncertainties that preoccupied investors as the reporting season approached. Meanwhile, in Europe, we have received earnings from just under half of the Stoxx 600 components. Positive sales surprises have accounted for 75% of the total, and positive earnings surprises have done so for 65% of companies that have published reports. Similar to the US, these numbers are broadly in line with those from the last couple of quarters. Banks' results have also displayed resilience, although some report slightly lower capital ratios primarily due to anticipated regulatory changes. In summary, the overall picture is a healthy earnings season.
Although we are not necessarily extrapolating these trends for the remainder of the year and fully appreciate the uncertainty posed by Russia's invasion of Ukraine, the commodities rally and China's Covid lockdowns, this earnings season highlights that the corporate sector is facing these challenges from a position of strength. For example, high yield credit metrics do not look stretched broadly speaking and are trending in the right direction, as expected. The US market shows steeper declines in leverage than the European one, although there have been changes in the indices, making comparisons a bit tricky. Moreover, ratings migration in both US high yield and Western European high yield (once we exclude Russian and Ukrainian entities that, for some reason, remain included in Bloomberg's Western Europe category) also display positive trends. According to Moody's, upgrades to downgrades ratios in the US and Western Europe (ex- Russia and Ukraine) stand at 1.68x and 1.14x in 2022. Likewise, investment-grade corporates are also healthy; Moody's has upgraded 6.25 companies for every downgrade in the US, while in Western Europe, the number is precisely 1.0 so far this year.
In our view, the fact that balance sheets and credit metrics are healthy and, for the most part, still improving will not impede a recession or a severe slowdown. Indeed, the Fed and other major central banks (excluding China and Japan) are actively trying to cause aggregated demand to slow down to bring inflation back to target levels in time. However, the consequences of said event and the economy's ability to withstand higher rates will differ dramatically if balance sheets are healthy versus a scenario in which they are not. The same logic applies to consumers and, very importantly, to the banking sector. Not all recessions or slowdowns bring about a pronounced default cycle, and the starting position of corporate health plays a crucial role. So far, this earnings season is telling us the starting point is a strong one.