Much has been written about the potential impact of a Dodd-Frank rollback on bank credit fundamentals. Nick Elfner unpacks the positives and negatives of the rollback and gives our perspective.
Key Drivers for the Quarter
- Corporates reported double-digit growth in operating profits in 1Q18. Tariffs are a key future uncertainty.
- Still solid U.S. bank capital ratios are poised to decline. Higher shareholder rewards are the primary culprit.
- Industrials continue to lever up. Buybacks, mergers and dividends are a preferred use of repatriated cash.
- Rising event risk and geopolitical issues. Idiosyncratic risk is increasing, driven by technological disruption.
- Foreign flows are slowing. Net corporate purchases turned negative for this important source of demand.
Heading into Extras
Now entering its 10th year, the U.S. economic expansion is beginning to feel like it’s in extra innings. A parent who watches a Little League summer baseball game knows that it can be an extended event with short periods of excitement. As summer baseball and the business cycle wear on, idiosyncratic events seem to be popping up more. An 8-year old kid may pound a triple and reach home on an errant throw caused by late-game fatigue. A large cap, blue-chip company can badly miss earnings forecasts, cut its dividend and initiate a strategic realignment. Our point is that late in any game or credit cycle, unexpected events occur that may alter the course of the game. With the Federal Reserve (Fed) continuing to raise short-term interest rates – driving a flattening yield curve bias – and as U.S. and China tariff battles are set to begin, we expect volatility to continue in the U.S. investment grade (IG) corporate bond market.
Fundamentals: Divergence in Leverage Trends
Strength: Solid Economy and Operating Trends
U.S. real GDP grew by 2 percent in 1Q18, consumer confidence is high, and unemployment is low. S&P 500 companies reported year-over-year growth in sales and operating earnings of 5.7 percent and 10.6 percent, respectively, in 1Q18. Top-line growth reflected improved demand while the U.S. tax cut buoyed the bottom line. However, European and Japanese economic growth have recently disappointed and the strong U.S. dollar is a headwind for emerging markets (EM). While the base case outlook for corporate profits is constructive, a full-blown trade war could derail it and drive increased volatility.
Strength: Solid Bank Capital Is Set to Decline
U.S. banking sector leverage at 10.9x (assets/equity) is below previous recessionary (1991, 2001 and 2009) peaks. U.S. bank capital ratios are solid but set to decline with rising shareholder rewards and regulatory relief. Regulatory relief supports near-term earnings for U.S. regional banks. However, a more lightly regulated banking system may increase risks over time.
Risk: Industrials Continue to Lever Up
Due to organic growth and tax cuts, first quarter earnings were strong. Profit margins improved on continued expense discipline. However, leverage remains high and we are still mostly seeing buybacks, M&A and other shareholder-friendly uses of cash from repatriation, rather than any material debt reduction or capex. Gross leverage at 2.5x for IG issuers is above previous U.S. recessionary periods when it typically peaks. Leverage is high among Industrial issuers due to companies’ aggressive credit stance and indifference toward the maintenance of high credit ratings. Concentration within U.S. business has increased at the largest firms across multiple industries. High market shares, larger scale and scope, and greater incidences of duopoly and oligopoly structures among IG issuers act as a partial counterbalance to more elevated debt leverage.
Risk: Rising Event Risk and Geopolitical Concerns
Global M&A increased by 20 percent year-over-year in 2Q18. Idiosyncratic risk seems to be rising, driven in part by tax reform, technological disruption, product sustainability issues and debt-financed mergers. While unpredictable, idiosyncratic risks may be minimized through increasing sector and issuer diversification and through bottom-up, issuer-specific research focused on material credit and ESG risks. Separately, U.S. foreign policy volatility and threats to impose tariffs on some products and sectors on trading partners and allies may strain foreign relations. And, U.S. government tensions with North Korea, Iran, Russia and/or China may periodically drive a “flight to quality.”
Risk: Credit Downgrades Are Potentially Coming
Rating agency actions for a specific issuer may have a material impact on corporate bond valuations. Potential global corporate bond downgrades (e.g. issuers with negative outlooks or ratings on CreditWatch with negative implications) numbered 518 in May 2018, exceeding 349 potential bond upgrades for a potential ratio of 1.5:1, per S&P Global Ratings. Record levels of merger activity and share buybacks during an extended low-interest rate period have contributed to high debt accumulation on corporate balance sheets and have arguably weighed on relative creditworthiness.
Technicals: Net Issuance and Foreign Flows Slowed
Increased Demand from Insurers and Households
Gross IG corporate new issuance was 5 percent higher year-over-year in 2Q18 and M&A has been a major driver. Six months into 2018, IG bonds have already matched the full 2017 M&A-related supply, per J.P. Morgan. However, net IG corporate supply declined in 2Q18 due to high redemptions and tax reform, which prompted a spike in issuance in 4Q17. IG bond mutual funds have reported $5 billion of net inflows in 2Q18 and $39 billion year-to-date in 2018 as compared to $26 billion in 2Q17 and $61 billion for 2017 year-to-date. Retail demand (e.g. fund flows) has seemingly been negatively impacted by weak IG corporate bond total returns year-to-date, along with high interest rate volatility. Demand for corporate bond issues from foreigners has slowed partly due to higher hedging costs, while insurance sector buying has increased moderately, potentially on higher all-in corporate yields. The household sector has also recently stepped up corporate bond purchases, per Fed data.
Summary: Sector Views
Divergence in Sector Fundamentals
Our corporate research analysts conduct broad sector scans for investment opportunities. Issuer creditworthiness and material ESG risks are evaluated through rigorous analysis. Our analysts’ sector outlooks and relative value assessments inform our Investment Committee as it formulates strategy and sets risk exposures for sectors within the corporate allocation of our Government Credit strategies. In the table below, our analysts have identified three corporate sectors with credit and ESG fundamentals that we believe to be stable, and three with negative trends.
Spreads have widened year-to-date, but we continue to see risks in IG corporates as the credit cycle looks late-stage, demand trends are uncertain, and a trade war and geopolitical risks are impacting volatility and risk assets. Given challenges in U.S. IG corporates, we maintain a higher-quality bias, with an overweight in corporates rated AA and A, and an underweight to BBB-rated issuers. Within the corporate asset allocation, on a contribution-to-duration (CTD) basis, our Intermediate Government Credit Strategy is overweight the Banking, Energy, Insurance and Pharma/Healthcare sectors, and underweight the Basic Industry, REIT and Transportation sectors.
Credit Trends Dashboard
In our Credit Trends Dashboard, we capture our views of the key drivers of IG corporate credit.
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