TIME FOR QUALITY

  • As we approach the end of the economic cycle, corporate profit margins are likely to suffer
  • US corporate debt levels are also a concern and lower margins could impact debt repayments
  • We believe it is time for equity investors to ensure they are exposed to quality stocks that can provide capital protection during challenging markets

Overview

Almost a year ago, in our paper A New Volatility Regime, we drew attention to a new environment that we were seeing for equities. One with more volatility and more bear market phases. We also highlighted the decreasing number of good quality stocks in the US on the back of rising interest rates and their impact on already highly leveraged companies.

Today, despite a more dovish tone coming from the US Federal Reserve, we are approaching the end of the economic cycle and this is leading to a revision of earnings growth. This is also likely to bring to light the high level of leverage characterising the US market. Against such a backdrop, we believe it is time for investors to focus on quality.

The Epilogue of an Endless Cycle

The S&P 500 index has delivered very strong performance since the Global Financial Crisis (GFC): over the last 10 years, it has returned almost 14% per annum. As Figure 1 highlights, the 10-year rolling annual performance of the S&P 500 index is now back toward extreme levels.

 

Figure 1: Performance of the S&P 500 Index is Approaching Extreme Levels

Figure 1 Performance of the S&P 500 Index is Approaching Extreme Levels
Source: Bloomberg, Unigestion. Data as at 31.12.2018.

 

This gives us a clue as to how long (and strong) the cycle has been so far. While corporate margins were supported by the lower interest rate environment and the recent fiscal stimulus measures, indebtedness has reached extraordinary levels, especially within the US small- and mid-cap universe, as shown in Figure 2.

 

Figure 2: Russell 2000 Index – Profit Margins & Net Debt to EBITDA Levels

Profit Margins

Profit Margins

Net Debt to EBITDA Levels

Net Debt to EBITDA Levels
Source: Bloomberg, Unigestion. Data as at 31.12.2018.

 

The levels of these metrics are clearly ringing alarm bells about the sustainability of the US equity market’s strength. The erosion of margins, combined with the strong levels of leverage, could lead to repayment issues and, at worst, trigger defaults and bankruptcies. More generally, another way to understand the situation in terms of leverage is to have a look at outstanding corporate debt as a percentage of GDP, which is fast approaching worrying levels.

Alarm bells are ringing as to the sustainability of the US equity market’s strength.

 

Figure 3: Outstanding US Corporate Debt as a Percentage of GDP is on the Rise

Figure 3 Outstanding US Corporate Debt as a Percentage of GDP is on the Rise
Sources: Bloomberg, Unigestion. Data as at 30.09.2018.

 

In our opinion, investors need to be cautious about the ballooning levels of US corporate debt and target quality companies that are characterised by their strong balance sheets.

Invest in What You Understand

Markets may have forgotten, but we remember that it is risky to consider financial products, or even individual companies, without having a clear view on what’s on the inside and understanding the underlying mechanisms. During the subprime crisis, for example, many mortgage-backed securities contained overlooked loans with embedded risks that credit ratings or market values failed to capture. Investors often focus on valuation, earnings and income statements instead of considering the overall outlook for the company (including profitability, the ability to repay debt, etc.). However, events can then occur which could lead to dividend cuts, providing a stark reminder to investors about the hierarchy of payments when there is trouble.

It is risky to consider financial products without having a clear view on what’s on the inside.

A dividend cut is quite rare as it sends a very negative signal to investors, hence the danger of such announcements. It is not always an indication of an immediate bankruptcy, but often signals the prompt need for cash to face debt payments. Many corporate bonds will mature in the next five years and we believe that huge amounts of debt, due at a time when profit margins are likely to shrink, will pose a significant risk.

 

Figure 4: Upcoming Maturity of US Corporate Debt is at Worrying Levels

Figure 4 Upcoming Maturity of US Corporate Debt is at Worrying Levels
Source: Bloomberg, Unigestion. Data as at 31.12.2018.

 

We believe these repayments will have a significant impact and the consequent erosion of profit margins will push many companies to review their dividend policy or, in worst case scenarios, will put them in a position where they are unable to repay their bonds at maturity, triggering downgrades of their credit scores/ratings.

Corporate debt levels and an erosion in profit margins are likely to impact dividends.

The current risk of company defaults is often measured by the high yield default rate, which is unsurprisingly correlated (with a lag) to the level of corporate debt, as Figure 5 demonstrates.

 

Figure 5: High Yield Defaults vs Corporate Debt Levels

Figure 5 High Yield Defaults vs Corporate Debt Levels
Source: Moody’s Analytics. Data as at 30.09.2018.

 

In our opinion, the dangers of default spread beyond the high yield universe.

However, there are a number of reasons why we believe that the dangers spread beyond just the high yield universe and why investors need to be accordingly cautious:

  1. Credit ratings have shown their limits in the past
  2. We are likely to see investment grade companies go directly to default
  3. BBB-rated companies, whose debt is in danger of slipping into high yield territory, may have trouble meeting their obligations during the next economic downturn, and their share prices could suffer, especially if their credit rating is downgraded

The final point made above is of significant concern given the fact that the proportion of BBB-rated companies has increased significantly since the last GFC, as shown in Figure 6.

 

Figure 6: A Notable Increase in BBB-rated Companies

Figure 6 A Notable Increase in BBB-rated Companies
Source: Bloomberg, HSBC. Data as at 31.12.2018.

 

“Quality means doing it when no one is looking”, Henry Ford

We believe it is time for equity investors to ensure they are exposed to quality stocks that can provide capital protection during challenging markets. As we mentioned a year ago in our paper A New Volatility Regime, any defensive allocation should be made at a reasonable leverage, but quality should also come at a reasonable price too. It is important to remember that current levels of outstanding corporate debt are highly elevated, as illustrated by Figure 5 above, and position accordingly. And, with the US market looking very expensive, investors need to take action sooner rather than later. In fact, it could be argued that market valuations are as scary as the levels of corporate debt.

An exposure to quality should provide capital protection during challenging markets.

 

Figure 7: US Corporate Debt as a Percenatge of Market Value

Figure 7 US Corporate Debt as a Percenatge of Market Value
Source: Federal Reserve Bank of St Louis. Data as at 30.06.2018.

 

Conclusion

In our opinion, the US market’s impressive rally could well end soon, triggered by the unmanageable levels of corporate debt. Any investor who is concerned about a potential market correction should be looking to minimise risk. Quality companies with strong balance sheets and attractive valuations could be the last ones standing when the market correction hits.

 


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