Commentary by Maria Colangelo, Vanguard senior credit analyst and co-head of the global industrials team, and Kunal Mehta, head of fixed income specialist team, Vanguard Europe.
Companies have on the whole surpassed earnings expectations throughout 2021, and this trend continued in the third quarter, buoying investor risk sentiment and pushing credit valuations to levels that reflect heightened optimism around fundamentals. While the Covid-19 pandemic has created pent-up demand across certain sectors, leading to supply-side bottlenecks and inflationary pressures, corporate pricing power has so far remained strong, which has been supportive for corporate profit margins.
The question is, against a backdrop of more persistent inflation and normalising monetary policy, is the current supportive environment for corporate credit spreads sustainable?
As the negative economic impact of Covid-19 has likely peaked and the third-quarter earnings season draws to a close, over 80% of the constituents of the S&P 500 index exceeded Q3 consensus earnings estimates, registering an average “beat rate” of 10%1. While the proportion of companies outperforming expectations represented a moderation relative to the two preceding quarters, it was still well above the historical average of around 66%2.
The S&P 500 financials sector outperformed other sectors in Q3, delivering an average beat rate of 20%3. This was roughly double the average beat across S&P 500 industrials of around 10%. Results for financials were bolstered by solid capital markets performance, the release of loan provisions and improvements in net interest income. Another bright spot was the recent pick-up in loan-market demand, which is sometimes viewed as an economic barometer for the health of the economy and the consumer.
Despite a recent soft patch, consumer sentiment remains at historically high levels and the strength of the consumer was evident in Q3 results across sectors, even as the economic recovery moved into the normalisation phase. Consumer behaviour is now shifting towards in-person, experience-based goods and services—notably the travel and leisure sectors—and away from goods and services which fared better when the pandemic was at its worst—such as the consumer staples sector. As a result, S&P 500 operating margins continued to expand in Q3, hitting a multi-year high of 17%4.
While earnings growth moderated in Q3 compared with the previous two quarters and inflation headwinds are growing, the outlook for corporate profits remains in an upward trend: consensus estimates point towards S&P 500 earnings growth for the full year 2022, and business fundamentals are still robust. Nevertheless, corporate credit faces a number of risks that could threaten the sustainability of earnings.
Margin risk is one threat. High demand has caused price inflation, which supply constraints have exacerbated. So far, companies on the whole have been able to pass through much of the cost increases they have experienced to end consumers. The question is whether they can sustain this.
The business cycle is another factor – and it’s not easy to define where we are in the current cycle. Inventories are depleted and need to be restocked; yet global growth is slowing - reflecting the stage of economic recovery from the pandemic, while the US Federal Reserve (Fed) is preparing to implement normalisation measures. We may currently be at mid-cycle so the risks to credit markets are moderate, but consumer sentiment in particular bears watching.
Monetary policy tightening is a key risk, too, and interest rates are extremely low given current economic activity and price inflation. Major central banks took a more hawkish tone during the third quarter and are carefully inching towards the first step in policy normalisation: reducing the level of their direct bond purchases. The Fed has started to reverse its QE policies, and the market is pricing rate increases for the second half of 2022. In the UK, markets are anticipating a rate hike in December after an expected October hike didn’t materialise, while the European Central Bank has also discussed tapering its support measures. These are expected and reasonable steps, in our view, but some market participants fear that central bank policy errors could damage the economy and markets.
These are not the only risks. Equity valuations are high by historical standards, and any material equity pullback—caused by higher interest rates or lower profit margins, for example—would likely cause credit spreads to widen.
As markets begin the path towards normalisation, we are likely to see increased credit dislocation across sectors, issuers and different maturity points, especially if some of these risks materialise. But this could also present attractive investment opportunities for active credit investors with the right approach.
In investment-grade credit, any spread widening could offer chances to add exposure at better prices, and with the sector fairly valued, performance in the coming months will probably come more from optimising yield rather than price appreciation.
Meanwhile, in high-yield credit, where opportunities for substantial price appreciation are also limited, there are many credits offering attractive carry in a yield-starved world, while “rising-star” companies poised to be upgraded to an investment-grade rating are attractive investments. Here, our rigorous crossover process enables us to selectively add rising stars and capture the spread dislocation. Emerging market credit offers strong potential too, although we are watchful of slowing growth in China and how that could affect other developing countries.
At Vanguard, we believe that risk-adjusted alpha is pivotal to consistency, and this is more critical than ever at times of heightened volatility. By deriving alpha from genuine, bottom-up security selection across diversified sources, without taking excessive top-down directional risk, investors can access more consistent alpha generation with less downside risk.
Our approach allows us to be patient and wait for attractive entry points to capture the best idiosyncratic alpha opportunities in select issuers, sectors and maturities whose spreads do not reflect their upside potential.
Find out more about active fixed income at Vanguard.
1 Source: Bloomberg as at 9 November 2021.
2 Source: Bloomberg as at 9 November 2021.
3 Source: Bloomberg as at 9 November 2021.
4 Source: Bloomberg as at 9 November 2021.
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