Profit cycle and credit market performance
New research from the PGIM Fixed Income strategy team has found that the corporate earnings cycle may be a more accurate indicator of credit market behavior than changes in GDP. The team looked at data going back over 70 years to analyze the relationship between credit spreads, GDP and earnings. Their conclusion: while correlations with spreads were negative for both factors, they were much more consistently negative for corporate earnings.
The finding is at odds with the traditional focus on GDP as a predictor of spread movements. According to Guillermo Felices, Ph.D., global investment strategist at PGIM Fixed Income, “Investors tend to favor GDP because it is a highly visible indicator of the profit cycle, since profits are generally high when GDP is high and vice versa. But we found periods of strong GDP growth where earnings growth was anemic or even declining.
Additionally, the study looked at periods when spreads widened by more than 50% year over year. “While many of these corrections happened during GDP recessions,” Felices said, “some didn’t. There were periods when GDP didn’t decline, but earnings were in a recession. For example, spreads began to widen in 1997, several years before the economic recession that began in March 2001.”
Headwinds for profits
In addition to looking at historical correlations with spreads, the PGIM Fixed Income study modeled the evolution of corporate earnings under five potential economic scenarios, ranging from recession to above-trend GDP growth. The study’s earnings growth indicator (ie earnings as a percentage of GDP) fell in all scenarios.
Kishlaya Pathak, CFA, senior investment strategist at PGIM Fixed Income, identified the key cyclical headwinds for earnings growth going forward:
The late phase of the current business cycle, in which rising labor wages – the largest component of business costs – put pressure on profit margins;
the aggressive tightening of the Federal Reserve, which increases the cost of capital and discourages companies from passing on their rising costs to consumers;
Inflation, which is fueling the current momentum of margin compression, driven by the combination of cost pressures and counter-cyclical Fed hikes;
The strong US dollar, which reduces the value of overseas earnings and hurts the competitiveness of US-made products by making imports cheaper.
Pathak cites two long-term structural headwinds as particularly important. The first is China. “Low labor costs – which were the basis of cheap Chinese exports and the root cause of the erosion of labor negotiations in the developed world – are increasing as the workforce work is aging and wages are rising,” he said. “More broadly, there is a growing trend of de-globalization. The focus on cost reduction is changing as political and logistical forces push companies to consider near-shoring and onshoring. All of these factors are negative for profitability.
George Jiranek, CFA, fixed income investment strategist at PGIM, saw additional structural headwinds for earnings. “The labor force participation rate is increasing but remains lower than before the pandemic,” he noted. “It’s important because it helps raise the wages of those in the workforce and deprives businesses of the workers they need to grow their revenues and earnings. We are also concerned about the possibility of an upward structural shift in energy and certain commodity prices, as well as geopolitical and economic uncertainty, which may make companies more cautious about investing and of expansion.
Cautious short-term outlook, longer-term opportunities
If PGIM Fixed Income’s analysis proves accurate, the outlook for credit markets would be cautious in the near term, but will likely lead to attractive opportunities and valuations for bond investors over the longer term.
“I would highlight a few concerns from a macro perspective,” Felices said. “The first is that we’ve had two decades of corporate earnings growing faster than GDP growth, which has provided a great backdrop for risky assets in general and credit markets in particular. But that period is now behind us. The environment we are moving into is much more difficult. More likely than not, earnings growth will remain anemic even as the economy expands.
The second concern, he added, is that “we are cyclically in a difficult situation, between a rock and a hard place. Even if growth is accelerating, it comes at the cost of accelerating costs, which means profit growth is expected to be very weak and likely below single digits. And after that, we expect a period of expansion that could be bumpy, simply because the kind of earnings growth we’ve become accustomed to just won’t be there.
The debate remains focused on the likelihood of an economic recession and credit markets are yet to fully price in the risk of lower earnings, which could potentially decline even if the economy escapes outright contraction.
Implications for Fixed Income Portfolios
How should plan sponsors position their fixed income portfolios for a period of declining corporate earnings? PGIM Fixed Income believes that the right approach is to be careful of credit risk in several short-term ways, while keeping a close eye on the timing of exploiting longer-term opportunities and disruptions.
Underweight riskier sectors. It is best to underweight positions in riskier sectors, such as high yield, leveraged loans, lower-rated municipalities and some sovereign debt.
Reduce exposure to high labor cost industries. Business credit allocations should favor industries with relatively low labor costs. As Jiranek explained, “One of the main reasons why we expect corporate profits to fall is a tight labor market, which shifts the balance of power towards the labor of the owners of capital. labor costs rise disproportionately for labor-intensive industries. If they cannot pass these costs on to consumers, their margins will be squeezed. As a result, we believe industries with a higher labor share will perform worse than industries with a lower labor share.
“We would probably avoid labor-intensive industries, such as healthcare, machinery, retail and restaurants,” Jiranek said. “The flip side would be to overweight industries that have a lighter labor footprint, such as agriculture, oil and gas utilities, real estate, and communications.”
Focus on sovereigns with stronger economic prospects. Among non-US sovereigns, Pathak noted, “there are exploitable regional divergences in terms of economic or geopolitical outlook. Europe is in a much more difficult position because of the Russia/Ukraine conflict, for example, and major importers of raw materials are affected. But there are also many energy-producing countries whose revenues benefit from high oil and gas prices. ■