Monday Musings: Quarterly Credit Update

Nov 15, 2021

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Public Trust Credit Team
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Companies continue to pay down debt while overall earnings increase at an unprecedented pace

Corporate earnings continue near-vertical growth. Following the earnings trough in December 2020, earnings have surged back 84.5% to a new high in Q3 2021. Companies across all sectors have capitalized on the global re-opening as well as increased consumer spending. As in previous quarters, the strong performance has been on the backs of the large tech players. We have also seen a gradual decline in overall net debt loads as many companies have utilized their excess cash and discretionary cash flows to lower their overall debt rather than stay on the hefty M&A spending path prior to COVID-19. Many companies have successfully managed the worldwide economic challenges and are now able to bring their leverage metrics back down to manageable levels; companies are also able to return to previous practices and focus on shareholder returns. Over Q3, corporate forward P/E ratios saw a 5.7% decline. Most companies, except for some of the tech giants who excelled during the pandemic, are realizing additional earnings in the near term as normal business operations resume. S&P EV/EBITDA saw a similar decrease over the quarter, dropping nearly 4%. Although the overall net cash did not experience a material change in either direction, the steep decrease in overall corporate debt is dragging down the average company’s EV. Coupled with the explosion of corporate earnings and the rapid rise of EBITDA across sectors, valuations are slowly becoming less rich.

Consumer credit fundamentals remain historically strong, potentially reflecting inflation pessimism

After a brief pause during the COVID-19 recession, consumers have experienced a tremendous ‘wealth effect.’ Average home prices have reached the highest on record with the strong investment market supporting consumers’ willingness to increase debt. The greatest contributor to the higher debt load was mortgages followed by autos across all FICO bands. Additionally, a recent Federal Reserve Bank of New York report showed that credit card balances are now increasing while balance paydowns have slowed; resulting consumer debt balances are returning to trend. However, the fundamentals of the consumer market remain robust with very low credit card losses and declining 90-day past due payments. The data additionally suggests that robust data is moving toward normalization as the rate of housing price appreciation is beginning to slow and consumer sentiment is declining. All of this tells us that consumer spending is strong and household debt is very manageable, but sentiment may be moderating judiciously due to inflation fears.

Global spreads remain tight due to the hunt for yield leading to minimal compensation for credit risk and an unusual correlation between bonds & equities

No matter where you look, spreads remain tight owing to a hunt for yield among global easy money policies. The LIBOR-OIS spread remains at historic lows, signaling that investors are not being compensated for credit risk even compared to periods such as the post-dot-com boom or post-Great Financial Crisis (GFC). Other proxies for credit risk tell similar stories. The option-adjusted spread (OAS) for the Bloomberg Barclay’s Agg is just above its historic low seen in 1997; the high-yield market OAS is at a historic low; and sector spreads remain below their averages post-GFC despite some selling last week. We expect that issuance will decline next year while corporate credit quality will continue improving, meaning spreads are likely to continue grinding tighter outside of an exogenous shock or Fed action.

This hunt for yield has led to an interesting global trend in the correlation between bonds and equities. During periods of strong equity performance, we typically see a negative correlation between bonds and equities. Because of the deluge of easy money, however, we are seeing increases in both equity and bond prices. This is due to the amount of money chasing returns across the equity and fixed income markets. Investors have been able to juice equity returns while also grinding spreads tighter, causing a reversal of the normal relationship between the two. Considering the volatility exhibited by the equity market during rate hikes, we expect this correlation to continue as the Fed raises interest rates, leading to an environment where the correlation is still positive but equity and bond prices are both falling.

The ISM Services Index reaches record highs on the back of robust demand

The October reading for the ISM Services Index hit 66.7, a 4.8 point increase from September’s reading of 61.9; this marks the highest print since the index’s inception in 2008. The strong report reflects the healthy demand in the services sector which reached a 12-month average of 61.1 and is the 17th consecutive month of growth in the industry after two months of contraction. Before contraction, the sector grew for 122 months. The largely positive news indicates an uptick in activity during Q4 21 but not without some nuances in the data. Decomposing the ISM Services PMI, multiple sub-indexes reveal strong demand growth. For example, the Backlog of Orders Index recorded 67.3 (+5.4 from September), and the Prices Index registered 82.9 (also +5.4 from September). Additionally, the Business Activity Index and New Orders Index posted all-time highs of 69.8 and 69.7 respectively, ideally signaling that supply-chain bottlenecks are not yet hampering demand. Given the ongoing inflationary pressures and shortages, supply chains reflect further strains given the supply-demand imbalance. While generally positive data is being reported within the sub-indexes, the Employment Index reported a decline of 1.4 (from 53.0 to 51.6), likely due to labor shortages and the challenging hiring atmosphere.

The ISM Manufacturing Index continues to see growth, albeit at a slower pace given widespread constraints

October’s print for the Manufacturing PMI Index reached 60.8, a modest decline of 0.3 points from September’s 61.1 reading. Breaking down the sub-index constituents, the New Orders Index was down 6.9 from September, registering 59.8, while the Prices Index read 85.7 (+4.5 M/M). The manufacturing segment continues to be constrained by record-long lead times for raw materials, shortage of critical materials, increased commodity prices, and transportation challenges. According to the Institute for Supply Management, “global pandemic-related issues — worker absenteeism, short-term shutdowns due to parts shortages, difficulties in filling open positions and overseas supply chain problems — continue to limit manufacturing growth potential.” That said, panelists from the Business Survey Committee at the ISM remain positively optimistic given the strong demand within manufacturing. The challenge is to work through the supply chain-related issues while demand remains robust.

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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