Conclusion: Leverage among U.S. corporations is currently indicating a level of speculative excess that has historically coincided with the onset of much-needed economic purging – i.e. a recession.
As mentioned in our 1/20 note titled, “Sentiment Update: Three Things I Learned Today (and Three Weeks From Now)”, Keith and I are in the full swing of our post-Quarterly Macro Themes marketing excursion. This week we’re out west visiting with clients and prospective clients in California after having made the rounds in Boston and NYC last week.
Sticking with the theme of the aforementioned note in terms of rebutting key points of contention that were as consensus as they were critical, we thought we’d take a stab at refuting the narrative fallacy that leverage among U.S. corporations is at a healthy level.
Nothing can be further from the truth.
The following chart is a little busy, but allow us to highlight the key takeaways:
- Despite the cost of debt financing (green line) falling to new all-time lows in the current cycle, aggregate corporate interest expense as a percentage of EBIT (white line) has marched steadily higher off of a secular higher-low and is now at 11.5%.
- This is likely due to the sheer amount of leverage on U.S. corporate balance sheets. Specifically, U.S. corporate debt outstanding as a percentage of aggregate corporate free cash flow (red line) just eclipsed four turns (4.1x to be exact). This is up from a secular low of 2.7x in early 2011.
- An economy-wide corporate debt/FCF ratio of ~4x meaningful because that level of leverage that has historically portended recessions in short order: 3.9x just prior to the 1990-91 recession, 4.1x just prior to the 2001 recession and 4.2x just prior to the Great Recession.
- Among the more interesting things to note in refutation of the narrative fallacy that “low rates = little-to-no #CreditCycle risk” are the secular lower-highs in the aforementioned interest expense/EBIT ratio. Specifically, the level this ratio reached just prior to the onset of recession has declined alongside the cost of capital in each successive economic cycle (25.2%, 22.1% and 15.5%, respectively).
- This is supportive of our view that there is no magic elevated level of interest expense that must be reached in order to see a recession commence. Moreover, this effectively implies low rates are not the panacea they are widely perceived to be in terms of staving off an economic downturn.
Source: Bloomberg L.P., Hedgeye Risk Management
How to Profit From This Realization
One conclusion we can all agree upon is that many U.S. corporations have taken advantage of low rates by levering up to finance “shareholder friendly” (read: “management compensation friendly”) activities. In fact, the past couple of years have seen record buyback and dividend activity among S&P 500 constituents.
As the ongoing corporate profit recession deepens, we highlight the obvious risk of companies allocating earnings to buybacks and dividends, rather than preserving cash and paying down debt. If our explicitly negative view on the domestic economic cycle continues to be corroborated by the data, then the growth rate of such payouts will likely have to slow dramatically – if not decline outright.
That is an obvious headwind to the broader equity market in terms of removing key cogs from the post-crisis secular bull case. It’s also an obvious headwind to individual equities as well. In that vein, the following 12 tickers are the output of a screen of U.S. corporations that may have become over-levered in the pursuit of such “shareholder friendly” activities:
Source: Bloomberg L.P., Hedgeye Risk Management
Specifically, the aforementioned screen looks for publically listed U.S. equities with market caps north of $1B that have seen double-digit growth in total debt over the past five years and negative geometric growth in basic shares outstanding (over the past five years as well) that are also in the top quartile of trailing five-year growth in gross dividends.
While admittedly crude, we think this list of names serves as a better-than-bad starting point for alpha-generating short/underweight candidates if you have been appropriately convinced of our bearish view on the domestic #CreditCycle.
In our 12/31 Early Look titled, “More Questions Than Answers”, we alluded to the fact that every crisis – either financial or economic – requires a broad-based refutation of a formerly widely-held belief. In light of that, we strongly posit the consensus view that zero percent interest rates equates to zero percent risk is one such widely-held belief that is being refuted almost daily by the market(s). As such, we believe investors would do well to adapt their belief system to incorporate such signals.
Best of luck out there today,