Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 371

The role of financial markets when earnings are falling

Over the years, the financial services industry has become needlessly complicated. Ultimately, investing still boils down to an exchange of capital today for cash flows tomorrow. Weaker balance sheets and income statements, dubious earnings assumptions and soaring bankruptcies demonstrate that a challenging investment environment lies ahead, but market pricing doesn’t reflect that outlook. Everything is rising in value because there is excess capital chasing too few opportunities.

Is that the role of financial markets?

Capital should be allocated more responsibly than that. The financial services industry of today looks quite different from a century ago, but its role in society has not changed. Back then, investing was the province of wealthy individuals and large institutions until companies such as MFS helped democratise markets and give small investors greater access to investments. At its core, investing is simple. It’s an exchange of capital today in return for a cash flow from a company or government in the future.

Against that backdrop, let’s take a look at what the price of risk is implying about future cash flows, though at this point it’s questionable whether the average investor even cares.

Weaker balance sheets and income statements

Long before the onset of the pandemic, worldwide profit margins had peaked and were contracting. Balance sheet quality was poor and deteriorating before the coronavirus spread around the world. Battling the spread of the COVID-19 forced a sharp curtailment of global economic activity in the first quarter, prompting companies to plug revenue gaps by issuing historic amounts of debt, materially weakening already fragile balance sheets.

At the same time, companies will incur incremental costs to minimise health risks for employees and customers, while many will also have to reorient supply chains to emphasise resiliency after many years of focusing more heavily on wringing out costs. This will weigh on income statements for those unable to offset higher costs with either higher prices or greater volumes. The resulting increased capital investment will lower return on working capital for years to come. In short, future cash flows are likely to underwhelm.

Fuzzy earnings maths

If companies are more indebted, have higher operating costs and greater output yet final demand remains below 2019 levels, how do the market’s implied 2021 operating earnings compute? Profits are not linear and the last few customers are always the most profitable. Scale matters immensely.

Absent revenue growth that is materially better than it was 2019, I honestly cannot make the earnings maths work.

Let’s look at this through a different lens. On annualised basis, the US economy contracted by a third this past quarter, a level materially worse than any quarter during the GFC.

The graph above illustrates that the number of sizable bankruptcy filings is on pace to exceed any year since the GFC. This makes sense to me. The imbalance in the real economy leading up to the 2008 recession was over-leveraged financial institutions. The imbalance was largely concentrated in one industry. This allowed the subsequent earnings recovery to be historically fast because most other sector constituents did not require equity recapitalisation.

How is 2020 different?

The weak economic recovery following the GFC and the central bank stimulus undertaken as a result of the weak rebound created more widespread imbalances during the just-ended cycle. The accommodative monetary backdrop afforded companies with weak revenues to substitute borrowed cash flows for operating cash flows. Unlike 2008, the 2020 crisis is one of over-leveraged businesses across many industries and sectors. The pandemic is the excuse often used for weak financial results, while the cause was soft demand heading into 2020, balance sheet fragility and financial engineering. As a result, I expect more bankruptcies during this recession and a weaker-than-normal recovery in overall profitability.

Why are financial markets signalling otherwise?

The honest answer is: who knows? I can offer this perspective.

While there are numerous asset classes for investors to choose from these days: growth or value equities, large versus small capitalisation stocks, developed market corporate bonds or developing, etc., ultimately there is only one asset class: volatility. Most financial assets are effectively short volatility, as they benefit when markets anticipate increasing certainty and stability. Conversely, they suffer when conditions deteriorate.

Assets such as US Treasuries or gold, on the other hand, are effectively long volatility and benefit from greater uncertainty. But lately, as policymakers have injected capital into financial markets to fund operating losses and suppress the cost of risk, the correlation between short and long volatility assets has gone from negative to positive. Today, everything is rising in value because there is excess capital chasing too few opportunities. Is that the role of financial markets? Capital should be allocated more responsibly than that.

Patience and skilled security selection and a focus on fundamentals are more important now than ever as the outlook for future cash flow deteriorates.

 

Robert M. Almeida is a Global Investment Strategist and Portfolio Manager at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

 

  •   19 August 2020
  • 2
  •      
  •   

RELATED ARTICLES

Why ESG assessment must now consider active ownership

Beware of burning down the barn to bury the debt

Amid vaccine hope and skepticism, testing is key

banner

Most viewed in recent weeks

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

13 ways to save money on your tax - legally

Thoughtful tax planning is a cornerstone of successful investing. This highlights 13 legal ways that you can reduce tax, preserve capital, and enhance long-term wealth across super, property, and shares.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Latest Updates

Investment strategies

Warren Buffett's final lesson

I’ve long seen Buffett as a flawed genius: a great investor though a man with shortcomings. With his final letter to Berkshire shareholders, I reflect on how my views of Buffett have changed and the legacy he leaves.

Property

The housing market is heading into choppy waters

With rates on hold and housing demand strong, lenders are pushing boundaries. As risky products return, borrowers should be cautious and not let clever marketing cloud their judgment.

Investment strategies

Dumb money triumphant

One sign of today's speculative market froth is that retail investors are winning, and winning big. It bears remarkable similarities to 1929 and 1999, and this story may not have a happy ending either.

Retirement

Can the sequence of investment returns ruin retirement?

Retirement outcomes aren’t just about average returns. The sequence of returns, good or bad, can dramatically shape how long super lasts. Understanding sequencing risk is key to managing longevity risk.

Strategy

How AI is changing search and what it means for Google

The use of generative AI in search is on the rise and has profound implications for search engines like Google, as well as for companies that rely on clicks to make sales.

Survey: Getting to know you, and your thoughts on Firstlinks

We’d love to get to know more about our readers, hear your thoughts on Firstlinks and see how we can make it better for you. Please complete this short survey, and have your say.

Investment strategies

A framework for understanding the AI investment boom

Technological leaps - from air travel to computing - has enriched society but squeezed margins. As AI accelerates, investors must separate progress from profitability to avoid repeating past mistakes.

Economy

The mystery behind modern spending choices

Today’s consumers are walking contradictions - craving simplicity in an age of abundance, privacy in a public world. These tensions tell a bigger story about what people truly value and why.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.