This article was originally published in Barron’s on August 29, 2023.
The resilience of US growth, earnings and markets has been the big surprise of 2023. Following more than a year of aggressive Federal Reserve (Fed) rate hikes, few would have believed at the beginning of this year that the United States would avoid a recession, see an upswing in US corporate earnings expectations, and enjoy a strong rebound of major equity indexes.
While many explanations have been offered to explain these phenomena, one important factor has been generally overlooked—US private sector debt. Over the past 15 years, US household and corporate sector indebtedness has changed significantly and in ways that make the economy, profits and equity valuations less sensitive to monetary policy than at any time in over a generation.
We will focus on the corporate debt story here. But we must note that household borrowing habits have also changed in important ways since the global financial crisis (GFC). Total household debt, as a share of gross domestic product (GDP), has fallen by nearly a third since 2008. Credit standards have tightened, with fewer at-risk households able to borrow or borrow as much. And, importantly, mortgage borrowing has reverted to conventional 30-year fixed rate mortgages and away from floating rate or adjustable-rate mortgages. As a result, the lags between the Fed’s short-rate hikes and debt servicing costs in the household sector have lengthened.
Those factors alone help explain why the US economy and consumer spending have held up better than many thought they would at the onset of 2023. A strong labor market, underpinned by post-COVID re-hiring, shortages of able-bodied workers, and fiscal stimulus have also contributed significantly to the resilience of demand.
But for economists, policymakers and investors, there has been another interesting debt development underway: the absence of any discernable impact of rising interest rates on corporate profitability. That outcome deserves closer attention, because it has important implications for growth, profits and equity as well as credit market outcomes.
What has changed?
Just as for the household sector, the GFC unleashed significant changes in the way companies borrow. Although overall corporate de-leveraging was more modest for companies than households since the GFC, a similar development has taken place in the tenor of borrowing. Specifically, one of the consequences of the GFC was to reduce company reliance on short-term borrowings such as commercial paper or bank loans and replace it with public and private credit instruments with longer maturities and fixed terms.
For example, the commercial paper market was roughly $2.2 trillion in mid-2007 and as of August 2023, it is close to $1.2 trillion.1 In that same span, US investment-grade and US high-yield debt markets have mushroomed from $2.1 trillion to $7.8 trillion, and from $0.7 trillion to $1.2 trillion respectively.2 Meanwhile, global private credit has grown by $1 trillion.3 Mostly, those borrowings are fixed rate and the average maturities across these three asset classes range from 4 to 10 years.
Accordingly, lags between rising interest rates (courtesy of Fed tightening) and corporate debt servicing costs have lengthened. As a result, the corporate sector, by virtue of structural changes in corporate finance, has thus far been sheltered from the harshest impacts of what has otherwise been an aggressive series of Fed rate hikes since early 2022.
But that is not all. As the most recent data for the second-quarter 2023 earnings season shows, companies across many sectors are reporting falling net interest costs, despite higher interest rates at all maturities. How is that possible?
Part of the answer resides in an inverted yield curve, with short-term rates above long-term rates. Companies with high cash balances (based on resilient earnings as well as prudent capital spending) are enjoying higher interest revenues by parking their money in short-dated notes, but low interest costs having locked in lower rates via longer-term borrowing. The corporate sector is, in sum, playing an inverted yield curve to its benefit.
That is a contributing factor to explain why, for virtually every sector in the S&P 500 Index (except for consumer staples and health care), net interest expense as a percentage of net profit is lower today than it was 20 years ago. Indeed, for the S&P 500 as whole, net interest expense as a percentage of net profit is today only about 40% of its 2003 level.4
The result is higher earnings—boosting share prices—as well as a more resilient corporate sector to Fed tightening.
But is this happy situation sustainable? In the long run, no. At some point, new borrowings are required and maturing debt must be rolled over. If borrowing costs remain elevated, the good times will go away.
But the corporate debt shield may yet endure for longer. That is because maturity extension has been significant for many companies and across many sectors. Since the end of 2020, for example, the proportion of investment-grade debt maturing after 2028 has gone from roughly 48% to 56%.5 This trend is even more pronounced among high yield (sub-investment grade) borrowers, with the proportion of borrowings extending beyond 2028 rising from 20% to roughly 42% of the market.6 And, of course, if rates fall between now and then (as would seem likely as inflation recedes), then companies may refinance on more agreeable terms before their debt matures.
It is also interesting to see where these developments are particularly significant. Within investment- grade markets, financials lead the way with a 50% increase in longer dated debt.7 The energy and technology sectors have witnessed increases of over 25%.8 At the other end of the borrowing spectrum, health care has not recorded a similar shift in debt maturity and, perhaps as a result, it has seen net interest expense take a bigger chunk out of net earnings in recent quarters.
The fact that profits have been shielded from the impacts of Fed tightening helps explain continued company interest in hiring. It also points to a positive feedback loop between profits, employment and demand that, while not sustainable forever, has helped to support US economic growth well into 2023.
If so, the resilience of earnings and growth has another key implication for investors—namely reduced default risk. Credit risk is more nuanced. Individual defaults remain possible, and some will be unavoidable. But barring a freezing up of lending markets, overall corporate default rates are likely to be lower in this cycle than in prior ones.
What are the key investment implications?
- First, we should be wary of recession forecasts based purely on historic norms. US private sector indebtedness has changed significantly in amount, structure, and maturity since the GFC and most of those changes lend greater stability and resilience to the economy.
- Second, assuming inflation continues to recede, and growth remains moderate, interest rates are probably near their peak. To the extent they fall from here, companies will be able to refinance on more favorable terms. For many of them, time is on their side, having locked into longer maturities.
- Third, investors ought to be prepared to use any bouts of overall weakness in credit markets to take advantage of improved corporate debt fundamentals. To be sure, doing so requires careful discrimination about where idiosyncratic credit risk is warranted, but in our view, prudent “buy-the-dips” approaches are justified.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
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1. Sources: US Securities and Exchange Commission, Federal Reserve. As of August 9, 2023.
2. Source: ICE BofA Indexes. As of August 9, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
3. Source: PitchBook’s 2022 Annual Global Private Debt Report. As of December 31, 2022.
4. Sources: Analysis by Franklin Templeton Institute, FactSet. As of June 30, 2023.
5. Sources: Analysis by Franklin Templeton Institute, ICE BofA Indexes. As of August 10, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.