The recovery from a deep recession can be intense. The proposition is even more acute in this recession, as continuing high levels of unemployment are accompanied by extraordinary issues of government policy and their unwind. Fundamentally, the asset at the heart of the crisis – housing – appears to be stabilizing in both the US and the UK. Corporate profits have done better than expected, as costs have been cut faster than prices. The rebound in auto, steel and non-energy materials production should set up the next leg of the recovery. Nonetheless, substantial risks remain; the consumer is getting some relief from lower prices, but confidence remains fragile, and there is a real risk that the S&P500 will retrace some of its recent gains. The real red herring for the market has been inflation, however we believe it is not a significant issue. Corporate profits now, and in the near term, are only likely to come from cost cutting. The fragile recovery should keep a cap on any notion of pricing power. Inflation staying low and getting lower – i.e., deflation – is the bogeyman to confront.
Markets showed corrective price action towards the end of the month. However, recent moves in the commodity markets and far eastern stock markets (China) are a reminder that despite the recent positivity in markets, we are prone to volatility given the rally is still largely based on “hope” that the recovery will be sustainable. Indeed the “new bubble” talk in China is an interesting school of thought that can be applied to western markets to a degree, along with increasing talk/debate about how central bank liquidity will be withdrawn in the west. This shows that we are drawing ever closer to a pivotal point in the credit crunch cycle, where the world will have to been weaned off the bosom of the central banks and have to fend for itself in the real world. What will likely emerge is a leaner fitter corporate world, but it will look nothing like the pre-crisis world; we will have high unemployment and high productivity but also a large output gap.
The corporate sector has been taking stern measures to repair its balance sheet and minimize the damage to credit quality. Thus, recent large cap company earnings have come in significantly better than expected. The bottom line has surprised and the top line has disappointed but, most importantly, both are up:
- More than 75% have beaten on the bottom line, the highest in a decade
- Earnings are up sequentially, notably with the largest increases amongst financial and consumer discretionary companies
- Sales are up sequentially
The firms that are beating estimates are, in general, low P/E, high EBITDA, and high growth firms that have shrunk their balance sheets. The market has rallied not only on the positive earnings surprises but also on an important coincident improvement in fundamental macro indicators.
Thus, high-yield spreads should narrow further as macroeconomic data improves and closed-end funds (CEFs) exposed to high yield debt should rally. A spate of positive earnings surprises combined with a healthy rally in equity prices point to a probable turning point in corporate sector credit quality, which will gradually increase the relative value of corporate loans and bonds. The default rate should peak around 12% near year end, and then drift down to 9% by mid-2010. Meanwhile, ratings migration (the ratio of ratings downgrades to total ratings changes) has improved. Historically, ratings migration for speculative grade issues improves ahead of the broader corporate market and this is often a signal of an upturn in corporate sector health.
Michael Ashley Schulman, CFA
Hollencrest Capital Management