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.

 

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

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Latest Updates

Taxation

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

7 key charts on the state of the Australian property market

The Australian property market stirs fierce debate - often bullish optimism versus crash predictions. But beyond the noise, seven charts reveal what's really driving prices and the outlook for residential real estate.

A simple alternative to the $3 million super tax

Division 296 aims to introduce improved fairness into the superannuation system, yet is overly complex. This scours the world for better ideas and suggests a simpler alternative which can achieve the same goals.

CBA and the index conundrum for super funds

After the hyperbolic rise in CBA shares, super funds are floating the idea of carving out the weightings of ASX bank securities and indexing them within their portfolios. This looks at why that might be a big error.

Strategy

10 policies to drive Australian productivity higher

Here's a comprehensive list of proposed reforms to fix Australia's stagnating economy, including introducing a flat income tax rate, reducing migration, and making childcare tax-deductible.

Interviews

Where to find big winners in Asia

As more money looks for a home outside the US, Asia may soon get some love. Fidelity's Anthony Srom outlines the best places in Asia to invest, including in Chinese consumer names, Indian financials, and Thailand.

Investment strategies

We have trouble understanding the time value of money

We overvalue the present and underestimate the future - it’s a cognitive glitch called hyperbolic discounting. It affects savings, spending, and loans, and it's more common - and costly - than we think. 

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.