Corporate Fundamentals: Weathering the impending storm
Since our blog last quarter, fundamentals for US companies have not changed materially, but the odds of a recession have grown markedly due to global central banks’ responses to sustained inflationary pressures. While fundamentals will likely weaken as monetary conditions tighten, we continue to believe that our investment universe of investment-grade and high-yield credits are well-positioned to weather the storm.
At our GFICC Investment Quarterly earlier in September, we concluded that the market will increasingly price in a recession as central banks hike rates to levels in excess of inflation. However, corporate fundamentals are lagging economic indicators. While companies including FedEx Corp. and Eastman Chemical have warned that the weakening macroeconomic environment will harm profits, we have yet to see broad-based deterioration in either income statements or balance sheets.
As we have expected, the pace of improvement in fundamentals for US companies has continued to moderate as shown in Figure 1. Year-over-year revenue growth for the second quarter was still positive for the median investment-grade and high-yield company at 12% and 16%, respectively, having slowed from 16% and 19%, respectively, in the prior quarter of 2022. Interestingly, high-yield companies continued to benefit from positive operating leverage with EBITDA growth of 18% exceeding revenue growth. However, this was a notable slowing from last quarter’s 28% increase. Investment-grade companies, presumably with pricing driving revenue growth but not enough to offset cost increases, experienced negative operating leverage this quarter.
Figure 1: Moderating fundamental improvement in US Investment Grade and High Yield companies
In the classic credit cycle, companies flow from the repair phase, in which they focus on balance sheet management, to the recovery phase, when leverage falls while cash flow grows, to the expansion phase, when managements increase leverage intentionally and speculative activity rises, to the downturn phase, when leverage rises before again moving into the repair phase amid an economic downturn. It’s a continuous cycle from recovery to expansion to downturn to repair. As noted in Figure 2, almost all sectors are in the expansion phase, which is associated with peaking fundamentals (Figure 1), rising leverage (Figure 5), increasing event risk, and the resumption of merger and acquisition activity.
Figure 2: Most sectors are in the expansion phase of the corporate credit cycle
Consistent with the expansion phase of the corporate credit cycle, leverage has increased. Companies have been using their significant cash balances to repurchase stock and to increase dividends. As shown in Figure 3, both investment-grade and high-yield companies have increased dividends and repurchases. Notably high-yield companies have shown a greater preference for buybacks recently. We think this is attributable to expected changes in tax policy which will render buybacks less favorable next year. Additionally, given the uncertain economic backdrop, companies may prefer share repurchases given they offer managements more flexibility.
Figure 3: Buybacks and dividends – curtailed, but now rising
As a result of increased repurchases and dividends, cash levels in both investment-grade and high-yield companies have fallen. However, Figure 4 shows that cash balances remain elevated compared to historical levels, offering financial flexibility.
Figure 4: Cash balances remain elevated
With share repurchases and dividends reducing cash balances, the delta between gross and net debt has shrunk. Additionally, as expected in the expansion phase of the credit cycle, the improvement in leverage has stalled and begun to rise. Figure 5 depicts leverage for median investment-grade and high-yield companies, which is lower than when the US economy entered recessions in 2019 and 2000, but higher than the 2007 recession. Overall, US companies, both investment grade and high yield, enter the coming recession in relatively strong shape.
Figure 5: Leverage ticking up
As upgrades of both high-yield and investment-grade credits have slowed, the upgrade/downgrade moving average has turned negative, as shown in Figure 6. We think this is a lagging indicator but note its importance to many of our clients. To that end, our Quantitative Solutions team has built a rating-migration framework based on our proprietary forward-looking rating indicator, which uses current ratings and outlooks and our assessment of ratings momentum, among other things, to forecast future ratings. In a mild recession, which would dent corporate profits, we expect modest ratings migrations in the Barclays US Investment Grade Index, as shown in Figure 7.
Figure 6: Declining upgrade/downgrade ratios
Figure 7: Ratings migration in a mild recession
Despite increasing odds of recession, we continue to believe that companies have the financial strength, flexibility, and discipline to withstand it.