Breaking US profits

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Naturally, the bond carnage has been feeding worries that something somewhere will somehow “break”. MainFT ran a good rundown of the usual suspects this morning. But there’s arguably one missing.

Thanks to resilient growth and the remarkable American consumer, listed US companies remain on average incredibly profitable, but the rising cost of debt is starting to become a small but noticeable drag on earnings.

Goldman Sachs estimates that returns on equity for the S&P 500 (ex financials, due to the distorting impact of Berkshire’s investment gains) has shrunk by 69 basis points this year to 23.4 per cent — and 31 bps of the contraction is because of higher interest payments.

This is obviously not a huge deal, and RoE remains at the 97th percentile since 1975. But it is a sign that one of the main drivers of US corporate profitability and stock market valuations over the past three decades is spluttering.

As a Fed paper pointed out earlier this year, lower interest expenses and tax rates explain 40 per cent of the real growth in US corporate profits between 1989 and 2019 (Alphaville wrote last month about an earlier version of the paper).

Many companies smartly locked in low rates in recent years with a splurge of fixed-rate, long-term bond sales. But Goldman’s David Kostin reckons that rising rates is becoming a greater danger to US earnings. His emphasis below:

In the new ‘higher for longer’ rates environment, the key risk for S&P 500 ROE will be higher interest expenses and lower leverage. Our rates strategists recently raised their forecast for the nominal 10Y UST and now expect rates to end 2023 at 4.3% and then rise to 4.6% in 1H 2024 before receding back to 4.3% at the end of 2024. Although the long-maturity, fixed-rate debt structures of S&P 500 companies generally insulate them from higher rates, borrow costs for S&P 500 companies have ticked up on a year/year basis by the largest amount in nearly two decades. If rates continue to rise or stay higher for longer, increased borrow costs would disincentivize companies to take on greater amounts of leverage.

A scenario in which interest expense and leverage persistently weigh on ROE would be a departure from the historical trend. The decades-long decline in rates has allowed companies to reduce their interest expense and utilize greater leverage to boost ROE. Since 1975, falling interest expense and greater leverage have contributed 18.5 pp of the overall 8.8 pp increase in S&P 500 ROE, while lower taxes have contributed 8.9 pp, higher EBIT margins contributed 5.9 pp, and lower asset turnover contributed -24.5 pp during the same period. A recent Fed paper similarly found that lower interest expenses and corporate tax rates explain more than 40% of the real growth in corporate profits from 1989 to 2019. Our own analysis of the long-term drivers of profitability found that declining cost of goods sold (COGS) has driven the remainder of the profit margin increases not driven by taxes or rates.

Now this clearly doesn’t fall in the “breaking!!” category. Rising bond yields have clearly singed equities lately, but when it comes to US corporate earnings it will be more of a slow burn than sudden flame death.

With one caveat: most big US listed companies are generally solid investment grade credits, but as the mainFT piece highlights, many have guzzled a bit too eagerly on cheap debt and are either in or teetering on the edge of junk territory.

And among smaller companies, the situation is more precarious. Distillate Capital just put out a report estimating that interest payments will consume almost 20 per cent of small-cap Ebitda this year, which could rise to over 30 per cent as bonds get refinanced at today’s current rates.

So far, investors don’t seem enormously worried about the US credit cycle. As you can see below, the option-adjusted spread of US high-yield bonds has edged up lately, but at 4.26 per cent it remains pretty subdued. All-in yields are much higher at 9.19 per cent due to the benchmark Treasury sell-off, but credit spreads aren’t exactly screaming panic.

Interestingly however, equity investors DO seem to be becoming increasingly nervous.

Here is Goldman’s custom index of US stocks rated in junk territory, versus the S&P 500 as a whole. Since late spring there has been a clear divergence in performance as investors have started to avoid weak balance sheet companies.

Perhaps this could end up being a rare example of equity market investors sniffing out and reacting to potential problems before bond investors?