INTRODUCTION As inflation continues to trend lower, most central banks appear to be done hiking interest rates. The European Central Bank...
Our survey[i] on corporate health in the third quarter painted a picture of an economy in transition. Even as some key fundamentals showed a marked deterioration from the previous quarter, others, notably the outlook for corporate credit, displayed surprising resilience. Given the macro backdrop, we expect further weakness from here. Going forward, we will be focused on two critical questions. How much weaker could the US economy get and how much damage could that do to credit?
In the third quarter, pricing power and profit margins both registered significant declines, a conclusion drawn from the work of our credit analysts who closely follow more than two dozen industries and the work of our macro strategies research team.
In our view, a key driver in the equation is the erosion of pricing power. As costs continue to rise, companies are less able to pass those expenses on to their customers. Weakening pricing power can be a double-edged sword. Over time, it could lead to a welcome decline in inflation. In the short run, however, it has been eating into profit margins. Profit growth for the S&P 500® Index has steadily declined in the first three quarters of 2022.
Pockets of strength
At the same time, the survey revealed signs of stability in some measures of corporate health. Leverage appears at manageable levels, defaults are currently low and the credit outlook has weakened only slightly. The vast majority of our analysts still are quite sanguine about credit. Only a small minority reported declines in credit quality in their industries. Few anticipate a developing crisis. That resilience could be attributed to a point we have made in previous posts: this corporate falloff started from high levels. Profit margins for the Russell 3000® Index, which represents 98 percent of publicly-traded US equities, reached an all-time high in Q4 2021. Even as margins have compressed this year, they have been relatively high by historical standards.
Leverage coming into this year was low because corporations used the long period of low interest rates to refinance their debt at attractive levels. Interest expense has not been a major burden. The upshot: companies have been able to maintain credit quality, even in the face of a weakening economy and stubbornly high inflation. Cost pressures eased in the third quarter, but only slightly.
The path forward
So that is where we have been. Where we go from here will likely be determined by a number of factors, none more important in our view than the future path of inflation. If prices continue to rise too quickly for the Federal Reserve, the central bank may be forced to raise rates more than the markets currently expect. Fed Chairman Jerome Powell ratcheted up those expectations in his most recent remarks.[ii] In general, the higher rates go, the greater the likelihood of a downturn.
In the past, corporate earnings have been a reliable guide to the economy’s direction. In the three recessions we have seen in this century, when corporate earnings peaked and started declining, payroll employment began to shrink at roughly the same time, ushering in a recession. That was true when the tech bubble burst in the early 2000s, in the financial crisis of 2007 to 2009 and in the brief COVID-induced recession of 2020.
The labor market has been a bright spot in 2022, though there have been growing reports of hiring freezes and layoffs. We will be closely following the labor market and corporate earnings for signs of further weakening.
In our view, most companies have sufficient strength to weather a downturn if it’s relatively shallow and brief. We say that knowing that all recessions are painful to those who have to bear the burden. In the event of a deeper and more prolonged slump, we would expect to see more defaults, more downgrades and wider spreads. While spreads have widened considerably this year, they are still nowhere near the levels reached in past recessions.
There is one more thing we’re keeping in mind. In the most recent recessions, the economy got considerable help from monetary and fiscal policy. The fiscal response in 2020 was particularly aggressive. Should a downturn develop this time, no such support seems likely given concerns about inflation. Markets seem aware that no one will be riding to the rescue and that may be one reason why we have seen so much volatility.
To sum up, we saw further deterioration in corporate health in the third quarter and we expect more weakening to come. To date, many companies have held their own in a difficult environment. Whether they can keep that up will largely depend on what happens to inflation, rates and the economy. We will be monitoring these factors going forward.
Written by Craig Burelle, Senior Macro Strategies Research Analyst
[i] Every quarter, Loomis Sayles’ macro strategies team surveys the firm’s credit research analysts. Responses are then quantified into diffusion indices, which we call the Credit Analyst Diffusion Indices (CANDIs), that measure changes in corporate health and the outlook for the next six months.
[ii] Chair Powell’s Press Conference, 2 November 2022.
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