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What do we know about the economy and credit markets?

 

There are currently many unknowns surrounding the economy and the capital markets.  We thought it would be useful to highlight what we do know about the current situation and what this could mean for credit markets.

In the equity markets, investors have the ability to look past near-term impacts to company fundamentals if they deem them to be temporary, since equity positions are perpetual.  In the credit markets, there are interest and principal payments that need to be made at particular points in time in order for investors to achieve their expected returns. Rick Rieder, Global Chief Investment Officer of Fixed Income at BlackRock, summed this up on a recent podcast by stating he focuses on liquidity, leverage, and cash flow when evaluating investment opportunities.  We can then use those three focuses as a framework for evaluating the economy and credit markets.

In terms of leverage, based on research by investment firm Guggenheim Investments, we know that high yield and bank loan leverage (debt to EBITDA) ended 2019 at higher levels than Q4 2008 (4.7 versus 3.5 for high yield and 5.4 versus 5.0 for banks loans).  We also know that certain segments of the high yield market had higher leverage than 2008.  For BB-rated high yield securities, leverage in 2019 averaged 4.1 and ended 2019 at 3.9, compared to 2.3 in 2008.  For B-rated high yield securities, leverage in 2019 averaged 5.3 and ended 2019 at 5.2, compared to 4.4 in 2008.  Many companies had a high amount of debt coming into 2019, giving them less room to use leverage to offset a weak growth outlook.

In terms of cash flow, also based on research by investment firm Guggenheim Investments, we know that year-over-year (y/y) EBITDA growth in 2019 averaged -1.7% for high yield and 2% for bank loans.

Source: Guggenheim Investments.

Source: Guggenheim Investments.

Source: Guggenheim Investments.

Source: Guggenheim Investments.

We also know that estimates for 2020 earnings are -20% y/y and -11% for revenues, based on FactSet data. 

Source: FactSet.

Source: FactSet.

This includes earnings estimates of -42% y/y in Q2 and -24% in Q3.  Cash flow was slowing for low-rated credits coming into 2020, and the earnings outlook for the next three quarters is quite negative. It is possible that earnings could take more than a year to return to prior levels after 2020.  Since 2019 was barely higher than 2018, 2021 could end with earnings growth having been flat for that three year time period.         

In terms of liquidity, based on research from investment firm TCW, we know companies took record drawdowns on their lines of credit, totaling $229 billion in Q1.

Source: TCW.

Source: TCW.

We also know that issuance in the investment grade market set records in March and April, with April totaling $297 billion.  High yield issuance also increased in April, growing to $37 billion from $4 billion in March.  It would appear companies have liquidity at the moment.

Source: TCW.

Source: TCW.

Source: TCW.

Source: TCW.

From an economic standpoint, we know that Gross Domestic Product (GDP) growth was trending lower in 2019 and that 2020 estimates expect record declines in Q2.

Source: FRED.

Source: FRED.

Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html . For data vendor disclaimers refer to www.ndr.com/vendorinfo/ .

Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/.

Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html . For data vendor disclaimers refer to www.ndr.com/vendorinfo/ .

Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/.

Source: FRED.

This will be a drag on consumption until it starts to normalize, which historically takes several years. 

We know that retail sales and industrial production have declined by record amounts and that this translates into significant lost revenue for multiple industries.  It will likely take a significant period of time for demand to get back to the levels seen at the end of 2019 and early 2020.  While that is occurring, it will be difficult for companies to add to their payrolls (in hours, wages, or headcount) or have the cash to make investments and service their debt payments.

Source: FRED.

Source: FRED.

Source: FRED.

Source: FRED.

Source: FRED.

Source: FRED.

Source: FRED.

Source: FRED.

While we continue to wait and see what happens in terms of the impact of the virus, there are some things we can monitor on the corporate and economic side that can help determine how credit risk is evolving. 

On the corporate side, we can watch company earnings, revenue, cash flow, leverage, and debt service coverage (liquidity, leverage, cash flow) trends and whether they are starting to move in the right direction.  This should also help determine if companies are seeing enough demand to get back to a profitability level that would allow them to hire, which would continue to boost demand.  

On the economic side, we can watch for signs that production and sales activities are starting to pick up, and how close they are to returning back to pre-shutdown levels.  This will be another indication of end demand trends, profitability, and future hiring.   

 

Rank Dawson, CFA
Vice President, Investment Strategy

Boyd Watterson Asset Management, LLC

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.