Today, the Fed faces an impossible situation. On the one hand, the US economic recovery is still fragile in a context of global growth weakened by the end of the commodities super-cycle. On the other, the virtual decade of ultra-accommodating monetary policy has caused collateral damage that can no longer be ignored. Indeed, the rising indebtedness of US businesses has been quite pronounced, even accelerating in recent months. Growth in profits has been too weak to contain leveraging, which has increased considerably since 2012, hitting its highest level in a decade this year. Over the third quarter, it stabilised thanks to a rise in profits. At present, however, the stakes remain considerable. In 2016, profits will remain sensitive to the trend in oil prices and, more generally, the dollar. In a context of higher rates, is such leveraging a risk?
US businesses have displayed very brisk growth in debt...
US companies have benefited greatly from the Fed’s ultra-accommodative monetary policy. Unprecedented and exceptional financing conditions have enabled companies to raise record amounts on the equity and bond markets. The IG bond market has virtually doubled in size in five years. This year, the volumes issued on the Investment Grade market rose 28% due to the very strong activity of US non-financial businesses. In all, these latter have raised nearly US$550 billion, which is a record, with annual growth of more than 70%. The issuers have also taken advantage of historically low interest rates by extending the average maturity of their debts and reducing financing costs. This year, issues on "10Y+" maturities reached unprecedented amounts.
... to finance M&As and asset buybacks, to the detriment of investment
Issuers have primarily funded M&A activity and share buybacks. Activity on these two markets has picked up and is now reaching the very high levels that prevailed before the crisis. Activity on the M&A market is essentially due to the proliferation of major transactions amid consolidation of the healthcare, telecommunications and energy sectors. Corporate cost-cutting is thus taking precedence over business investment. Against a backdrop of sluggish economic growth, businesses are being tasked with safeguarding their revenues and margins. The major players on the M&A market are the most active sectors on the primary market. The "usual suspects" are consumer staples, technology and energy. Investment spending, however, has been disappointing overall in light of the high levels of capital raised. The post-Lehman investment recovery has varied widely between different sectors. Most sectors are yet to rediscover their pre-crisis levels. With the recent decline in oil prices, only sectors tied to energy have witnessed a significant investment recovery.
The profit dynamic, though, has proven much less brisk, and highly varied...
Despite the length of the expansion cycle, the recovery turns out to be the softest in post-war history, which has resulted in relatively weak growth in earnings for businesses. It is extremely important to understand that the profit growth witnessed in recent years has been the fruit of higher margins much more than growth in revenues. Margins have increased due to significant contraction in production costs and, most importantly, a very limited rise in wages. Today, the potential for profits increasing via a rise in margins is extremely reduced: (1) margins are at historically high levels, and (2) the job market's vigour in the United States argues for a confirmation of the recent jump in wages.
This recovery is also characterised by a strong dichotomy between the manufacturing and non-manufacturing sectors. Declines in oil and commodity prices continue to affect the US manufacturing industry. The ISM Manufacturing Index fell from 50.1 to 48.6, its lowest level since June 2009. This weakness in commodity prices is a plus for consumers, boosting their purchasing power. US households are also benefiting from the job market's improved health. In 2016 and 2017, household demand is expected to remain the principal driver of the developed economies. Given the fact that consumer spending accounts for the lion's share of GDP in the advanced economies, household spending can offset (at least in the short run) a shock from external trade and the weakness of the manufacturing industry.
This top-down scenario can also be read bottom-up. Growth in US corporate profits is positive overall, even posting a net rebound in Q3, thanks to sustained growth in household consumption and a stabilisation in the dollar's effective exchange rate. Yet the uncoupling of consumption/communication sectors from sectors tied to energy and commodity prices is increasing. In fact, Q3 growth in profits shows more pronounced differences among the sectors: Consumer Staples (+9% yoy), Consumer Discretionary (+5%), Communication (+9%), Utilities (+5%), Industrial (+2.3%), and Energy (-13%).
... and remains sensitive to changes in the dollar and the price of oil
The dollar plays an essential role. The strong dollar severely affected profit growth in the first half of 2015. Its negative impact is cited by most businesses (source: Factset). The greenback's appreciation since mid-2014 has made the Fed "more prudent" in its intention to raise interest rates. The US dollar’s appreciation can be attributed mainly to the divergence of monetary policy between the Fed and the other developed countries’ central banks, as well as the deterioration of growth prospects in the emerging countries. The current cycle is unprecedented because the contribution of the emerging currencies to the dollar’s real appreciation is much stronger in relative terms (emerging currencies contribute more than half) than in previous cycles. In practice, the effects of the dollar's appreciation on activity are comparable to a tightening of monetary conditions. According to the Fed's estimate, all other things being equal, a 10% increase in the effective real foreign exchange rate is equivalent to a monetary tightening of 175 bp. It is the exporting businesses that suffer the most. First, their sales and profits made outside the US decline mechanically when converting into dollars. Second, their competitiveness suffers.
The fall in oil prices has had a negative impact on the energy and utilities sectors. We should reiterate here the high exposure of dollar bonds to the energy sector: 17% of the value of the IG debt market and 14% of the HY universe. Our scenario includes stabilisation of commodity prices.
In conclusion, there are two opposing risks:
The energy sector makes up 17% and 14% of the market value of IG and HY debt
The decline in oil prices has strongly affected growth in revenues and profits for issuers in the energy and base materials sector
The announcement of a wide-scale quantitative easing (QE) programme has accentuated the drop in eurozone sovereign bond yields. The interest rate on German 10-year bonds now hovers around 0.21%, or a 23bp drop since QE was officially announced on 22 January. In contrast, credit markets have posted lacklustre performance.
Valentine AINOUZ, Sergio BERTONCINI