To take some license with an old adage---- when the going gets tough, the tough seek shelter----- investors are preparing for further disappointment in the equity markets. By all accounts, investors have set the bar quite low and now expect a continuation of the decline in corporate earnings.

According to FactSet’s most recent report, the S&P 500 companies’ earnings are expected, in the aggregate, to fall by 4% per share in the third quarter (Figure 1). This follows two consecutive quarters of earnings decline. Margins are expected to decline by 11% in the most recent quarter, despite rather moderate growth in wages and commodity prices. In addition, with approximately 40% of sales coming from overseas operations, the large corporations are not expected to recover quickly from this downdraft in profits.

Almost all the major industrial and agricultural industries have been affected by US tariffs and that trade war continues to obscure the profit outlook into 2020.The major US banks, according to FactSet, will show about a 2% fall in earnings, as they contend with lower net interest rate margins in the wake of the Fed’s two most recent rate cuts. The worse sector performance is the energy sector which has been hardest hit by the fall in US crude prices and the build-up in inventories. Investors need to find shelter outside of the equity markets to preserve capital, let alone find higher returns.

Figure 1 Earnings Growth Forecast for 2019Q3

Investors have turned to the bond market as their ‘safe harbour’. We are all too familiar with the US Treasury yield curve inversion and the even more dramatic inversion in Europe where sovereign debt yields are negative at all points along the curve. 

Corporate bonds yields are calibrated in terms of their spreads over US Treasuries. On a risk-adjusted basis, investment grade corporate bonds have narrowed considerably this year from their recent high in January and now are approaching their all-time lows recorded in 2018 (Figure 2). By contrast, the high-yield corporate bond market has moved in the opposite direction, that is, spreads have widened further. The divergence between the investment grade and high-yield bond yields is a clear sign that there is concern with credit quality as investors adjust to the slow down in growth and the prospects for a near term recession.

Figure 2 Investment Grade Bond Spreads

While it seems comforting to seek shelter in corporate bonds, investors need to exercise considerable caution from two perspectives.

First, corporate bonds are an integral part of the capital structure of a company along with equity. Should that equity fail to provide adequate returns, corporate bonds will be under pressure and yields could widen further relative to government bond yields. Put differently, that widening indicates that risks have increased in the corporate sector. A corporate bond is only as good as the underlying strength of the company’s equity. Any assessment of the credit worthiness of a corporate bond, even one that is rated ‘investment rate’ must be made within that context. (Readers are reminded how fast GE’s debt moved from investment grade to junk bond status in recent memory). In late 2018, when the stock market fell dramatically, corporate bond spreads widened considerably from 1.4% to over 2% in very short order, reflecting the concern over a falling stock market.

Second, while investors might feel safe in owning high quality corporates, that trade is becoming very crowded. Any rush to the exit door could result in a sharp widening of the spread to the detriment of sellers. Investors are paying up a lot for safety, especially when that safety is tied to the valuations in the stock market.