Walk the Line: Credit Outlook for 2014
March 31, 2014 | By Tony Wong
- Invesco Fixed Income's (IFI) top-down macroeconomic outlook continues to be positive for credit, as we believe many of the concerns investors faced in 2013 — including policy uncertainty — will be alleviated in 2014, suggesting there's potential for stronger economic growth.
- Company managements have taken action in recent years that has been largely supportive of both credit assets and shareholders. Increasingly, however, they may face choices that prove more beneficial for shareholders, at the cost of being credit negative.
- We believe a bottom-up analysis of the fundamentals could help illuminate the need corporate managements have to adopt a strategy that maximizes their flexibility — allowing them to walk the line of pursuing growth cautiously. Credit investors will need to monitor these activities, as we believe security selection will be important for credit investors in 2014.
Goldilocks revisited: The credit environment in 2013
On balance, both the top-down macroeconomic environment and bottom-up fundamentals were supportive of credit assets in 2013.
- The moderate level of global economic activity constrained top-line revenue growth, with revenues and earnings growing about 2% and 5%, respectively, in 2013.
- The subdued level of economic activity led corporate management to focus on savings rather than investing, restraining capital expenditure (capex), which grew at a modest 1.5% in 2013, on a trailing 12-month basis.
- Company management focused on generating growth in earnings and enhancing shareholder value, with 97% of S&P 500 Index constituents paying dividends, buying stocks or both. Dividends totaled about $350 billion in 2013, while share buybacks totaled approximately $450 billion. At the same time, profit margins continued to expand — another 50 basis points (bps) to 9.7% — in 2013.
- In the face of political and economic policy uncertainty, the volume of activity for mergers and acquisitions (M&A) remained stagnant, despite strong drivers, including low-cost funding, record levels of corporate cash and attractive valuations. Globally, M&A volumes have been tracking about $2.5 trillion for the past three to five years, well below the $5 trillion level in 2007.
These factors provided an attractive environment for credit asset classes (see Figure 1), resulting in a low level of defaults, high interest coverage ratios1 and strong market appetite for corporate debt that allowed for the extension of debt maturity profiles.
Source: Bloomberg L.P. (Data as of 12/31/13)
Outlook for 2014
We are now entering the fifth year of the economic recovery. With the Federal Reserve (Fed) beginning to taper quantitative easing, we believe this will be a year of economic transition — as a liquidity and policy-focused economy makes way to one that is driven more by economic data and the way in which that data evolve relative to expectations. We believe the US economy will continue to expand in 2014, albeit still at a moderate pace of about 3%. This environment should continue to be supportive of credit. But with more upside possible from acceleration in economic growth, corporate management will need to create the flexibility necessary to invest in order to capture that potential upside while guarding against the possibility of another downturn.
Revenues: Growing slowly, but remaining at record-high levels
Historically, nominal gross domestic product (GDP) revenue trends have been correlated with revenue growth (see Figure 2), suggesting that, on average, top-line revenues will likely benefit from this higher-rate economic formation.
Source: Bloomberg L.P. (Data as of 12/31/13)
This IFI macro top-down view is supported by our credit teams' bottom-up fundamental analysis of industry revenue projections, which suggests above-average growth in some key sectors such as information technology, health care, consumer discretionary and consumer staples (see Figure 3). When combined, these sectors constitute 60% of the S&P 500 Index revenues and more than 50% of its earnings. However, with demand driving this upside and capacity still limited, we believe modest pricing power could emerge within some of these sectors. With more stable global growth and stronger domestic demand, we believe revenues will continue to grow at a faster pace relative to 2013, modestly higher than consensus expectations of 4%.
Source: FactSet Research Systems Inc. (Data as of 12/31/13)
Earnings: Feeling the drag from costs
Ongoing cost cutting — which we thought had largely run its course — continued in 2013, lifting corporate profitability as margins continued to expand to 9.7%. To provide context, at this level, margins are approximately 70 bps higher than precrisis levels and approximately 300 bps higher than in the mid-1990s. Not only could any additional cuts impede the ability of companies to quickly ramp up activity when demand increases, but we believe many companies — particularly in certain industry sectors — are facing pent-up pressure in some parts of their cost structure . The fading cost tailwinds could create pressure on additional margin expansion and a drag on the rate of earnings growth.
Given this context, while we do not believe margins are going to collapse, we think room for further material margin expansion is limited because:
- Larger companies — such as conglomerates and multinationals — which have been more proactive in balance-sheet management and cost-structure initiatives in recent years, have basically exhausted their options for additional material cost adjustment.
- Smaller, more levered companies, which until now have not participated as aggressively in operational cost cutting, may have additional refinancing opportunities to reduce their debtservicing cost, thereby contributing to further margin expansion.
Capital allocation strategy: Maximizing flexibility
Against this backdrop — stronger potential for upside, but plagued by continued uncertainty — corporate management is likely to focus on generating free cash flow to maximize its flexibility to pursue capex and/or M&A — if growth materializes — or to just continue paying back shareholders.
Facing ongoing economic and policy uncertainties in 2013, corporate management continued to focus capex on maintenance and productivity enhancement rather than on growth, increasing 1.2% on a trailing 12-month basis from $597 billion to $607 billion. A bottom-up sector analysis supports our belief that capex will continue to be flat in 2014, but suggests there are new developments in the composition of spending between sectors. Specifically, three sectors of the S&P 500 Index — telecommunications, energy and utilities, which accounted for approximately 50% of capex in 2013 — will likely spend less this year. We also see the landscape for capex beginning to shift in 2014 on two fronts, both of which we believe are positive.
- A lot of the investment and capex acceleration in energy and resource sectors have been completed. This means that sectors such as energy and metals and mining, which have been intensely capex heavy in recent years, are now in the position to harvest the cash flow from their investments. So while they are spending less on capex, their free cash flow contributes to their credit profile.
- More rapid capex growth is expected in sectors that are traditionally linked to consumerdriven US economic growth. Such sectors (see Figure 4), including information technology, health care and consumer (staples and discretionary), have been underinvesting over the past five years. We believe a more confident outlook for sectors that are more consumer driven may be a harbinger of potential higher growth in the US.
Viewed collectively, we do not believe that strength in the more service-oriented sectors will completely offset weakness in resource sectors to lift the aggregate level of capex significantly.
Source: FactSet, Research Systems Inc. data as of Dec. 31, 2013
Similarly, we believe that M&A activity — which benefited from all the necessary drivers, but nevertheless failed to take off as expected in 2013 — will grow only modestly in our base case for 2014, as conditions are at the margins less conducive than they were a year ago. However, resurgence of animal spirits in the corporate sector could impact this base case. For example, leverage-financed M&A activity tends to occur during periods of more benign economic conditions. Such activity is particularly detrimental to higher-rated issuers.
If, however, US economic growth does not materialize as expected, corporate management will likely continue to focus on shareholders through increases in dividends and share buybacks. While these distributions totaled approximately 800 billion in 2013 — as measured against net income of $1 trillion and earnings before interest, taxes, depreciation and amortization (EBITDA) of $2 trillion — there's capacity for further increases without material releveraging at the aggregate level. Specifically, while buybacks increased 20% in 2013 to $450 billion, they remain well below the $600 billion precrisis level, even though precrisis earnings were substantially lower than they are today. We therefore believe that companies will continue to ramp up their distributions in 2014, with a preference for allocating incremental dollars to buybacks over dividends — as the latter represents more of a long-term commitment by corporate management to shareholders. Consequently, we expect dividends will grow more in line with earnings, and given the significant capacity for buybacks based on free cash flow, firms could potentially add more than $150 billion to $200 billion in buybacks without increasing aggregate leverage.
In walking this line between having the potential to capture the upside and seeking protection against the headwinds of a still uncertain recovery, we don't believe companies will venture too far in either direction. Regardless, we believe generating free cash flow to maximize flexibility will be key, which places firms — from a fundamental perspective — in a solid position to generate good outcomes.
For credit investors: A year of transition
For investors in credit risk assets, this year of transition continues to hold unique opportunities. We believe the macro environment &mdash accelerated growth and subdued inflation &mdash will continue to be supportive of fundamentals across many credit asset classes, even as the Fed begins to withdraw liquidity from the markets. And with a more constructive outlook for corporate health, certain segments, such as high yield and bank loans, could offer a level of income and return that is very attractive on a risk-adjusted basis relative to fundamentals in an environment where defaults remain at historical lows. Given valuations and the focus on how data will evolve, we do not expect returns to be evenly generated over 2014, so agile teams that can take advantage of ebbs and flows in the market should benefit investors.
We also believe selective screening of companies will be a stronger driver of performance this year, as changes in corporate financial policies at the individual firm level could have a material impact on issuer and security level valuations. IFI is well positioned to help investors with this analysis with the help of our experienced credit research team of professionals, who have weathered many different economic cycles while working together for more than a decade. In the process, they've created a rigorous and exhaustive proprietary bottom-up fundamental credit analysis framework to help monitor companies, minimize issuer credit risk and find opportunities for clients.
1 The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.
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