Corporate credit: Humpty Dumpty exudes optimism

Peter Warburton - 3 October 2019

Next Thursday (10 October) we offer a breakfast seminar cheerily titled “The coming collapse of corporate credit.” A dark cloud has descended on the corporate sector due to the coincidence of labour-related and materials cost acceleration and top-line revenue deceleration. Overlaid on the macro picture is a progressive rightward-skew in corporate profitability and a leftward-skew in net debt. While highly profitable companies have retained healthy earnings momentum, a long fat tail of underperforming business is suffering disproportionate damage to profits and cashflows. Meanwhile, S&P’s credit upgrades to downgrades ratio of US corporate debt sinks down the page.  Humpty Dumpty still gives a good interview, but the cracks are unmistakable.
In our research publications we have been flagging this issue all year: that a global profits downturn took hold in the second half of 2018 and is gradually extending its influence. Tariff escalation and other restrictive trade practices are aggravating the situation as dominant firms seek to mitigate tariff impacts on customer prices. Profit margins are being squeezed from all sides. Another pop in oil prices would be the final straw. 

Global nominal GDP growth, which peaked at 6.4 per cent per annum in 2018 Q2, has slipped under 5 per cent for the first time since 2016. About a dozen countries, out of 53, are bucking the trend but figure 1 indicates the degree of negative bias in nominal GDP momentum. In some European countries, nominal growth is bloated by inventory accumulation and this may be responsible for some of the credit acceleration that has recently occurred. If further inventory shedding is underway then this is unlikely to carry a positive message for profitability.

Historically, the flattening of the yield curve has preceded a much lower US corporate profits-to-GDP ratio (figure 2) over the following 2 years. The logic underpinning this relationship is twofold. There is the familiar historical proposition that a flat/inverted yield precedes a cyclical downturn in activity (which erodes profitability), but also the less familiar regularity that the rate of profitability follows the cost of capital with a lag. The weaker is capital discipline, the more likely it is that capital will be unwisely deployed, with predictable consequences for returns.

In this extended environment of ready access to affordable bank credit and bond finance, capital has been very patient. Cash-burning businesses have had their plans indulged as never before. Since the fourth quarter of last year investors have raised their levels of suspicion and scrutiny and investor flows have become much more discerning. The credit downgrades (figure 3) are coming thick and fast. Watch out for the unfolding credit default cycle, irrespective of corporate and central bank assurances.  

Figure 1: 

Data source: Thomson Reuters Datastream and EP calculations

Figure 2: 

Data source: Eikon Reuters

Figure 3: 

Data source: Bloomberg

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