As at 16 January 2024
Author: Andrew Bevan, Partner and Economic Advisor
- Andy Bevan, Fulcrum’s Economic Advisor and fixed income specialist, has prepared this note on the financial condition of the US corporate sector.
- The latest US national financial accounts were released in early December. These show the financial position of the non-financial corporate sector in robust shape to withstand the effects of the cumulative tightening in monetary policy since 2022 H1. Recession risks stemming from an over-stretched company sector seem abnormally low for this stage of the cycle.
- In 2023 Q3, before-tax profits remained close to the highest level since before the Great Financial Crisis (GFC) and the sector again had no overall reliance on external funds. Corporate debt as a share of GDP has continued to fall since the pandemic crisis.
- Corporate bond spreads are fully priced for a “soft landing” of the economy. Neutral exposure is justified toward investment-grade bonds, where spreads sit close to long-term average. Risks are skewed toward higher default rates and spreads on sub-investment grade bonds.
No Imminent Sign of Recession Risk from US Corporates
US corporate after-tax profits increased slightly as a share of GDP in 2023 Q3 and remained close to the highest level for more than 50 years. Similarly, before-tax profits increased slightly and remain close to the highest levels since the 1970s (see Graph 1). The performance of profits is remarkable in view of the steep rise in producers’ costs, but the economic environment has become more challenging as financial conditions have tightened.
Graph 1: US Before-Tax Corporate Profits, % of GDP1
Source: FRED, Fulcrum Asset Management
The ratio of corporate debt to GDP was 49.6% in 2023 Q3 – significantly lower than the peak of 60.5% in 2020 Q2.2 This has returned to the pre-pandemic level and is only about three percentage points above the cyclical peaks witnessed over the past 30 years.
Conventional measures of leverage remain reasonably well-behaved. The ratio of debt to the market value of equity increased slightly and is higher than in mid-2021 but remains close to its lowest level for more than 50-years. Debt to net worth with assets valued at replacement cost remains close to the average level that has held since the mid-1990s.
The nonfinancial corporate sector had a negative “financing gap” for the third consecutive quarter in 2023 Q3 (see Graph 2). Remarkably, abstracting from short-term swings associated with the pandemic, the sector has had no overall reliance on external funds since the end of 2019 despite the solid rebound in business investment expenditure.
Graph 2: US Financing Gap, % of GDP3
Source: FRED, Fulcrum Asset Management
The ratio of liquid assets to short-term liabilities has fallen steeply from a recent peak of close to 100% in mid-2021 but it remains above the average of the past 20 years.
Total corporate bond issuance in 2023 remained slightly below the average of 2012-2019. The Securities Industrial and Financial Markets Association (SIFMA) reports total corporate bond issuance of $1.44trn in 2023 – up slightly from $1.37trn in 2022.
High Yield issuance increased more significantly from the very depressed level of 2022 but remained well-below the annual average of 2012-2019.
Asset Backed Securities (ABS) issuance remained depressed in 2023, below the annual average of the past decade and still less than half of the typical volume seen pre-GFC. Collateralized Debt/Loan Obligation (CDO/CLO) issuance was negligible and remains depressed compared with the past five years. Non-Agency Commercial and Residential Mortgage-Backed Securities (CMBS and RMBS) issuance has never recovered since the GFC.
Total returns in the leveraged loan market were +11.6% in 2023 after -1.8% in 2022. High Yield bond returns were +13.5% in 2023 after -11.2% in 2022.4
The trailing 12-month High Yield bond default rate picked up to 3.0% in December5– still below the long-term average of about 3.9% and the 8-10% default rate typically seen in recessions. Defaults are likely to increase further this year if the economic environment remains challenging.
Turning to valuation, the Moody’s Baa index spread has fallen steeply since mid-year and now sits close to the long-term average measured since 1985. By contrast, the spread on the Barcap High Yield index is close to one standard deviation below its average of the past thirty years.
Overall, corporate bonds are priced for a “soft landing” in the economy. Credit fundamentals justify a neutral stance on investment-grade corporate bonds but with more caution on sub-investment grade exposure.