Monday Musings: Quarterly Credit Update

Jun 26, 2022


Public Trust Credit Team

Companies have been returning capital to shareholders at an astonishing rate, but they may not have enough gas in the tank to continue.

Returns to shareholders from the S&P 500 companies has risen ~55% from March 31, 2021, to May 31, 2022, representing the most drastic climb in recorded history. Most companies paused share repurchases in early 2020 in anticipation of the future or in response to the global pandemic. Numerous large corporations were able to weather the initial storm and resumed substantial share buybacks in mid-2021, ramping up their programs to over-compensate for the interruption. The financing gap, an indicator of cash generation, has recently been decreasing just as quickly as shareholder returns have been increasing. This disconnect tells us that companies will eventually need to scale back their programs as the resources needed to fund them will soon be insufficient. We are also seeing the near-vertical increase in corporate earnings since January 2021 start to level-off, showing stimulus spending is coming to an end and the music is about to stop for the S&P 500 corporate names. An eerily similar pattern can be recognized pattern was seen immediately prior to the Global Financial Crisis (GFC) in which the rising shareholder returns and declining cash generation both hit a breaking point and immediately flipped directions. Almost simultaneously, corporate earnings reached an inflection point and began its sharp decline. If companies fail to recognize the ramifications of these trend continuations, the overall credit health of the S&P 500 could be in trouble sooner rather than later.

Lending likely peaked, with data suggesting recession next.

Bank lending over the quarter continued growing, although business cycle lending has likely peaked and will decline in response to rising rates and tighter lending standards. Growing demand for commercial and industrial (C&I) loans was the primary driver of growth in bank lending and most of these loans are variable rate. Demand grew in part from businesses moving forward with capital expenditures that were postponed during the pandemic and intentional increasing of inventories to combat supply chain pressures. The Fed’s more aggressive monetary policy is expected to spur tighter underwriting standards which should moderate the substantial growth trend of recent years. Commercial real estate (CRE) lending has been robust in recent quarters and is highly correlated to GDP growth. According to a recent Federal Reserve study, bank “loan balance growth slows, and loan rates and collateralization requirements rise, in the year following a contraction in the supply of C&I loans”. This suggests that the Fed’s actions are clearly flowing through to lending reduction, very likely presaging a recession. Similarly, domestic home price growth has remained at cycle highs and is expected to moderate in response to stricter residential lending requirements and mortgage rates increasing at the fastest pace on record.

Households continue seeking credit while lenders showing more conservatism.

Households continue to modestly increase indebtedness, with debt/GDP at levels comparable to that of Q4 in 2009. This is due to the past years’ increase in several categories including revolving lines of credit (largely credit cards). Until lately, credit was easily attainable, but lenders have recently become more wary of subprime and near prime auto loans at the same time that credit card charge offs are showing an upward trend. However, it is worth noting the recent retrenchment began at a point of historically strong consumer health. Path dependence is always a consideration in economics, and while the data are worth watching, we do not see any cause for alarm.

Investors look to quality, causing a dramatic repricing in credit markets.

Rate hikes, war, and recession fears have dramatically reshaped spreads across fixed income markets in the U.S. In the corporate market, all sectors have continued to see widening though the sectors are following a more normal trend. Defensives, such as healthcare and utilities, have seen the least widening while more economically sensitive sectors, such as consumer and financials, have seen the most. It is also worth noting that the Bloomberg Barclays Investment Grade Aggregate index has seen its spread increase 80 bps since December and it now sits at the wide end of its typical non-recession spread. All of this selling has led the market to begin to demand more for credit protection as U.S. Investment Grade Credit Default Swaps have seen their spreads nearly double since the beginning of the year. To judge how we got here and where we are likely to go, we highlight correlations, volatility, and financial conditions. Correlations of bonds and equities have spiked to levels we typically see during financial turmoil but how long they remain elevated will be the most telling indicator as we haven’t seen a prolonged positive correlation between the two assets since the GFC. Volatility has spiked and surpassed the levels seen during the COVID quarantines, however, we note that volatility remains well below the levels it saw in the GFC and dot-com bust. Finally, financial conditions turned negative in February and have continued to decline since. Financial conditions remain much more favorable than they were during the GFC and 2020. However, we do believe that as the Fed continues to raise rates and the financial markets continue to be volatile, we expect financial conditions to continue moving negative for the rest of the year.

Equity investors and company owners are not seeing eye to eye on valuations.

The current S&P 500 Price to Earnings ratio of ~18.0x is nearly identical to that of the pre-pandemic business cycle. However, the current S&P 500 Enterprise Value (EV)/EBITDA compared to the previous cycle is considerably higher. This indicates that public investors in these companies are less optimistic than their controlling parties. It also demonstrates it is cheaper to buy the equity of the company on a relative basis, highlighting the premium an investor would face if control were priority. The stark disparity between current and past EV/EBITDA’s is a signal of the additional debt incurred by corporations in recent years, during which many companies took on due to the cheap borrowing costs. The now inflated company valuations should price out most potential buyers, leading us to believe that future mergers and acquisitions are likely limited to cash rich companies.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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