Fixed Income
Many factors contribute to the difference, or spread, between corporate bond yields and those on U.S. Treasury securities. Since Treasurys are generally regarded as free of default risk, the yield gap between corporates and Treasurys can largely be attributed to those characteristics that affect corporate default risk.
In our analysis, we focus on three key metrics that are often associated with corporate default risk: profits, cash flow, and balance sheets. The stronger corporate profits are, the less likely companies will default on their debts. Company earnings for the economy as a whole hit a record high in 2014 (Chart 1). While profits probably suffered a setback in this year’s first quarter, most analysts expect them to resume their upward trend later in 2015.
Like profits, cash flow is regarded as an important indicator of a company’s ability to meet its debt servicing obligations. U.S. corporate cash flow hit a record $2,095 billion in 2010. Since that peak, cash flow pulled back by about 2 percent to $2,046 billion last year. That is a small decline given that cash flow has grown at an annualized rate of over 7 percent for more than 60 years, rising from $22.6 billion in 1950 to more than $2 trillion last year.
Excessive debt on corporate balance sheets is generally regarded as increasing the risk of default. Unfortunately there is no hard-and-fast rule to determine what’s excessive. Historically, the ratio of debt to net worth in nonfinancial corporate sectors has risen from a low of around 20 percent in the early 1950s to a high of over 50 percent in 1993. As of last year, the ratio stood at just under 37 percent, only about 1.5 percentage points above the long-term average of 35.4 percent.
At least partially as a result of these risk factors, corporate bond spreads over Treasurys are close to the long-term average of about 2 percentage points (Chart 4), suggesting that bond investors consider the overall health of the corporate sector to be reasonably good. Another important pattern is the tendency for these spreads to widen sharply during recessions and to narrow during stronger economic periods. This makes sense, since stronger economic growth should help companies improve profits and cash flow, reducing default risk. If economic growth does reaccelerate as we expect, corporate bond spreads may narrow from current levels.
Commodities
A question often asked by commodity investors or those considering allocating a percentage of their portfolios to commodities is: Is it better to buy precious metals directly or buy the stocks of precious-metal miners? The retrospective answer depends on what historical period you use as a guide.
Since 2001, diversified mining stocks have been a much more volatile investment compared with gold miners or investing directly in metals (Chart 5). Up until November 2013, diversified mining stocks outperformed the other groups by a wide margin, but a sharp decline in the price of those stocks has left their performance much closer to just buying the precious metal.
Gold mining stocks were the worst performers of the four, rising just 5.7 percent since 2001. Buying a basket of industrial metals would have resulted in a gain of about 120 percent since 2001. Investing in gold would have provided a gain of about 340 percent, while buying a group of diversified mining stocks would have delivered a return of 345 percent, excluding dividends. However, the diversified mining group would have experienced much greater swings in price compared with the other alternatives.
Based on the performance since 2001, investors who chose to add gold as their commodity allocation would have been rewarded with a favorable combination of higher return with lower risk compared to these other commodity investments.
U.S. Equities
As we have discussed, the U.S. corporate sector is benefiting from moderate sales growth and solid balance sheets as well as high profit margins, earnings, and cash flow.
However, S&P 500 companies may collectively report declines in sales, margins, and earnings for this year’s first quarter. Through May 1, approximately 360 companies included in the index have reported results for the period. Combining the actual results with the latest consensus estimates for companies that have not reported yet suggests total sales may have fallen 2.6 percent from a year ago, while earnings per share may rise just 2.0 percent. However, excluding energy companies, which have been heavily affected by the plunge in oil prices, sales probably rose 2.3 percent from a year ago and earnings per share likely gained 8.5 percent. However, quarter-to-quarter fluctuations are normal and should be largely disregarded. It’s important to take a longer-term view when considering macroeconomic forces and their impact on capital markets.
Given the economic backdrop, we believe one of the key factors for the equity market going forward will be the ability of companies to maintain high profit margins, especially as some signs of rising labor costs have begun to emerge. For example, the Employment Cost Index from the Bureau of Labor Statistics showed that wages and salaries for all U.S. workers rose at a 2.5 percent annual rate in the first three months of this year, the fastest pace since the fourth quarter of 2009. With labor costs often accounting for a major share of their total spending, it will be important for companies to find offsetting expense reductions or productivity enhancements. Alternatively, corporations may try to maintain margins and profits by passing along price increases to customers while trying to avoid losing market share.
In general, high profit rates suggest strength for a business, with favorable fundamentals such as a good competitive position with strong demand, efficient production, or the power to maintain prices. However, high margins also suggest a bigger risk of future declines. Among the 10 equity-market sectors, all but one have average margins over the past five years that are greater than their 15-year average (Chart 6). It will be particularly important for companies in these sectors to protect margins, especially as labor cost pressures rise.
Global Equities
Similar logic applies to the analysis of global corporate profit rates; high margins suggest strong business models and favorable conditions, but margins that are too far above long-term averages could suggest a higher risk of future declines.
Margins for the S&P 500 from 2010 through March 2015 averaged 8.7 percent, higher than for companies in other developed countries and regions. In fact, the United States is the only developed market in this group with margins above 8 percent (Chart 7). However, as in similarly mature regions, U.S. company margins are above the long-term average, suggesting elevated risk.
Emerging markets and Asia excluding Japan have shorter-run average margins above 8 percent, similar to the U.S., but in both cases, slightly below longer-term averages. This could suggest somewhat lower risk associated with maintaining profit rates over coming quarters.
For Europe and developed markets excluding the U.S. and Japan, margins trail other regions on an absolute basis and yet are running above their longer-run average. Based on this particular metric and analysis, investors should be careful when considering buying into these markets.