The final numbers for the S&P 500’s corporate earnings just came in this week as the first reports from early reporters for the first quarter are just beginning to trickle in. A decline has been expected for quite some time, so it was no surprise when the index’s earnings fell year over year, marking the second consecutive quarterly decline and the first time this has happened since 2009.
Corporate earnings may signal recession
Corporate earnings for the fourth quarter were also the worst they’ve been since 2009, and when they decline, it can be one of the first indicators that a recession is imminent, lending credence to the argument that we’ll see a recession very soon. Bank of America Merrill Lynch HY Credit Strategist Michael Contopoulos and his team explained why this is so in a report dated March 29.
They said that when companies are struggling to increase their bottom lines, they seek liquidity through other routes, like the capital markets or by cutting costs. But when it’s not possible for a company to get funding or it becomes too expensive to do so, they end up scaling back, either in capital expenditures or by cutting jobs.
Concerns about the high-yield market
Contopoulos and team said last week’s second revision to fourth quarter gross domestic product has given them even more concern about the high-yield market. They note that on the headline, it was an upward revision of 0.4%, bringing it to 1.4%. Their focus is the 7.6% decline in corporate earnings, which they said reinforces their concerns about “a shaky fundamental backdrop” for high-yield.
“With negative ex-Commodities YoY EBITDA growth in 3 of the last 5 quarters, increasingly high asset impairment charges, and weak free cash flow generation, we believe major fundamental problems within high yield exist but have been obfuscated by the increasingly common use of adjusted EBITDA as a measure of credit health,” they wrote. “And when coupled with a consumer that is showing initial signs of weakness, we believe further troubles may lie ahead for high yield corporates as they struggle to generate cash through organic means.”
Recessions and the credit cycle
The BAML team noted that a recession in the U.S. isn’t necessarily a requirement for the credit cycle to turn, but its influence on the picture of the next default wave should be noted. They’re still examining the many other macroeconomic factors and how they could impact company health. Their main concern is that following the second consecutive year over year decline in corporate earnings, when paired with lower worker productivity and higher wages, “the very rosy jobs numbers may begin to disappoint.”
While most other firms are emphasizing the positivity in the macro numbers, the BAML high-yield team seems especially concerned about them and particularly what they could mean for the potential of a recession and a downturn in the credit market.
They highlight that while personal spending has increased in each of the last three months, it’s been only a miniscule 0.1% increase. Despite this increase, they think consumer spending habits have been more conservative than they should be because of how low gas prices have been and the current jobs numbers. They also warn that if the jobs numbers start to disappoint, consumers could quickly pull back and start saving more.
What this could mean for the high-yield market
The BAML team explains that the U.S. economy is so fragile right now that even a “marginally weaker spending” might seriously impact the companies that are the most vulnerable, triggering a chain reaction that could start if they end up being forced to liquidate, fire employees, and then default on their credit. Contopolous and team adds that just the possibility that labor slack will increase might result in consumer spending pulling back even more, thus causing stress on the next weakest links.
“This self-perpetuating cycle, should it continue, could create a rolling blackout as defaults migrate from one sector to the next,” they cautioned. “And while Energy and Materials are currently in the crosshairs, we could envision a number of sectors that could come into focus and prove unable to withstand the added stress of a weaker consumer.
As a result, they will be paying more attention to corporate earnings and other fundamentals and how vulnerable supposedly “healthy” high-yield sectors may be to a wave of defaults that could spill over I into other industries. As a result, they’re not buyers of the high-yield market and think spreads will be forced wider by fundamentals.