Corporate Fundamentals: Living in interesting times
Despite inflationary headwinds and geopolitical concerns, corporate fundamentals remain healthy. With central banks fighting inflation and recessionary risks rising, the macroeconomic backdrop has deteriorated in the last quarter; nevertheless, most corporates across developed and emerging markets have ample financial flexibility.
Figure 1: Moderating fundamental improvement in US and European Investment Grade companies
Year-Over-Year EBITDA Growth
US and European Investment Grade
EM: Potential outcomes for 2022 EBITDA growth
After phenomenal growth in 2021, the pace of revenue and EBITDA growth has moderated. As we wrote last quarter, the recovery phase of this credit cycle, in which cash flow and margins rise and leverage falls, is behind us. We don’t know whether central bank tightening and military conflict will truncate the expansion phase of the credit cycle and move us quickly to the downturn phase, but risks to global growth are rising. As a result, we have increased the likelihood of below-trend growth, recession, and crisis from last quarter. However, we continue to believe that above-trend growth remains the most likely scenario for 2022. From a bottom-up perspective, which is our primary focus, the outlook for profit growth is less robust across developed and emerging economies. Consensus forecasts call for 13% EBITDA growth for the median US investment-grade company in 2022, following 18% growth in 2021. We now think it likely that EBITDA growth for the median European investment-grade company will fall shy of US growth, despite our view that Europe is in the earlier, recovery phase of the credit cycle compared to US, which is in the expansion phase.
With rising inflation and macro risks, we expect significant dispersion in growth rates across sectors. Some sectors, including Airlines, Energy, and Retail, which are in the recovery phase of the credit cycle, should continue to grow cash flow and margins this year. Most sectors, especially in the US, however, are in the expansion phase which corresponds to rising idiosyncratic risk.
Most investment-grade and high-yield companies have limited direct exposure to Russia or Ukraine and recent divestments and withdrawals have had minimal credit impact. The conflict is obviously more acute in emerging markets, where our team has introduced a bear case, in the event of prolonged military conflict in Ukraine, in which EBITDA will fall in 2022. We continue to monitor second-order effects across our investable universe. The largest, as noted above, is risk to overall macro-economic growth.
Figure 2: Consensus forecasts continued margin expansion
Operating Margins, US Investment Grade & EU Investment Grade
Despite inflationary pressures and ongoing supply-chain disruptions, consensus estimates forecast continued improvement in operating margins from record-high levels. We think this is unlikely, although we were prematurely skeptical last year. More recently we have begun to see consumer resistance to increased prices in some investment-grade sectors, as shown in Figure 3, while Energy and Healthcare companies continued to expand margins in Q4. Commodity exposure will also benefit overall margins in EM due to their relative weight in the universe. Across developed and emerging markets, companies can withstand margin compression given the high current levels.
Figure 3: Dispersion in operating margins
Rising operating margins in Energy and Healthcare
Continued improvement in commodities benefits overall EM margins
Despite a less rosy outlook for EBITDA growth, leverage across developed and emerging market corporates, for both investment-grade and high-yield companies, is near the lowest levels seen in several years.
Figure 4: Sustained deltas between gross and net leverage across regions
High Yield Leverage
Emerging Market Corporate Net leverage still low
We continue to observe a material gap between gross and net leverage. As we have highlighted previously, and as shown in Figure 5, investment-grade and high-yield companies hold material cash balances in developed and emerging markets, both as a percent of their outstanding debt as well as assets. However, as we anticipated, cash levels have declined somewhat from recent peaks as companies have begun to increase or reinstate dividends, share repurchases, and capital expenditures. We expect this trend to continue in 2022 with a resultant decline in elevated cash balances. However, we note the overall strength of European investment grade corporates, where cash represents more than 40% of debt levels.
Figure 5: Cash balances remain elevated
Emerging Market corporates have significant cash
As we have written previously, corporations capitalized on low interest rates, refinancing debt to lower their future interest expense. Lower interest expense and improving EBITDA have translated into enhanced coverage ratios across investment-grade and high-yield companies in the US, Europe, and emerging markets.
We are doubtful that capital markets will be as accessible to corporates as they were in 2021 when significant issuance across all fixed-income markets enabled companies to refinance existing debt, reduce future interest expense, and extend maturities. While investment-grade issuance remains robust, year-to-date issuance in high-yield markets for both developed and emerging markets has fallen sharply from 2021. Nevertheless, a significant portion of our coverage universe can meet debt obligations without accessing capital markets, as shown in Figure 5. Like cash levels, coverage levels in Europe are particularly healthy, as shown in Figure 6. With the prospect of rising rates and moderating fundamentals, we don’t expect further improvement in coverage levels, as measured by trailing-twelve-month adjusted EBITDA to interest expense.
Figure 6: Improving coverage ratios in developed and emerging markets
Emerging Market Corporate Interest Coverage ratio
As shown in Figure 7, the ratio of rating-agency upgrades to downgrades has moderated recently. In the last three months, downgrades have exceeded upgrades across developed and emerging markets for both investment-grade and high-yield companies. While the number of downgrades has remained relatively constant, the pace of upgrades has slowed sharply. Many of the fallen angels of 2020 have returned to the investment-grade universe. It’s likely that the pace of upgrades to downgrades has peaked for this cycle.
Figure 7: Rating agency upgrades are outpacing downgrade
While inflation provides a boost to top-line revenue growth for many industries, cost pressures may offset that boost, especially in sectors where consumers resist price hikes. With rising input costs and rates, company management teams will continue to search for growth levers for earnings. Year-to-date declines in share prices may dampen buybacks, which tend to be correlated with equity markets, but we continue to see rising risks for corporate actions that may be detrimental to bondholders. Bottom-up fundamental research remains critical to successful investing across investment-grade and high-yield sectors.