Chief Investment Officers from Franklin Templeton specialist investment managers share their view on corporate health in the US across fixed income and equities asset classes.
Michael Buchanan, Co-Chief Investment Officer, Western Asset says: “Corporations continue to operate conservatively with elevated levels of cash on hand. In this environment, I’m not 100% sure a slowdown is inevitable. The economy has been amazingly resilient.
“There’s some talk that there’s a maturity wall coming in 2024 or 2025 but it’s really not the case with below-investment grade credits. When you look at the combined bank loan and high yield markets, we see about US$260 billion that needs to be refinanced by the end of 2025. That’s less than 10% of the overall market, which seems manageable.
“The concern about a maturity wall is more appropriate for the investment grade market, and that is a byproduct of just how much issuance we saw during the Covid period. We’re on pace to price about US$1.2 trillion of bonds between 2000 and 2023. That’s basically what we’ve seen every year for the past decade, except for 2020, which was a record year. We don’t think there’s a daunting refinancing hurdle for the investment grade market either.
“Still, there are areas of vulnerability. The size of the BBB- universe on negative outlook is historically low, at about 12%, compared to the 24% of all BBB- rated credits.
“We do need to be careful because monetary policy works with long and variable lags. Obviously, the longer we stay at these elevated levels, lower-quality companies could feel a pinch as well as companies that rely on significant floating-rate financing.
“Higher-quality high yield bonds will endure. Both the investment grade and high yield markets, on a spread basis, have performed reasonably well. Investment grade, depending on which index you look at, is marginally tighter. High yield had really gotten off to a nice start and then widened back out.
“The best performing category has been securities with CCC ratings. But you can’t just make a valuation call solely based on spreads. You have to look at the intersection of fundamentals and spreads. And when we do that, relative value looks decent.
“If the U.S. Federal Reserve navigates the economy to a soft landing, the upside should be pretty significant, given the absolute level of yields and the potential for spread compression. But if things get a little worse and we’re heading into either a mild recession or something more severe, we think higher-quality high yield bonds will endure whereas the lower-rated, higher beta categories are going to have more volatility. In investment grade bonds, a higher quality bias is warranted.
“There are idiosyncratic opportunities outside the U.S. Europe is obviously a challenged economic story. The CCC cohort in Europe is the worst performing category within high yield in contrast to the U.S. Emerging markets and frontier markets have U.S. dollar-denominated bonds that have become very cheap.
“Everyone’s talking about commercial real estate, in particular the office sector. There’s been a lot of disruption and we think there is probably more to come. But, at some point, it could present a unique opportunity.
“And we like duration. Now that we’re closing in on the end of the tightening cycle, that’s historically been a good time to own duration. It’s a nice complement to a diversified fixed income portfolio – it tends to do well when other risk sectors are getting hit. Duration in Europe, because of the economic challenges there, looks interesting.”
Also read: US Government Debt: We Need To Talk
Scott Glasser, Chief Investment Officer, ClearBridge Investments says: “Corporate health is very solid. A lot of companies had locked in lower rates at the beginning of Covid. Looking at high yield maturity schedules, there’s very little coming due in the next year–about 3% in 2024–and then that ticks up to 10%, but you don’t have a lot of refinancings going on in the next 12-18 months.
“But we’re starting to see some cracks. If you look out to next year, 2024 earnings estimates are supposed to be up about 12%. That’s going to be difficult with pressure from higher interest rates, the higher U.S. dollar and higher energy costs. I think that number will be about 6%.
“Stock buybacks are running at about 1.7% of market cap. The average over the last 10 years has been about 2.1%, down from 2.5%. That indicates companies are being more careful with their cash. It may be a reflection of lower valuations or it may be a reflection of the economic unknowns over the next six to 12 months.
“From a large cap perspective, interest coverage on these companies is running at about 8.4X. The average over the last 30 years has been about 6.3X. Operating margins are running at about 11.5X. The peak was about 13.5X, but the range has been 8X-12X.
“For small caps, the historical average is about 2X interest coverage. But over 40% of the small cap stocks in the Russell 2000 are not profitable. Over the last 10 years, those numbers have climbed significantly. If you look at equity performance across the different market cap buckets, small caps have lagged the most.
“There is growing evidence of economic slowdown when we look at consumer health. Like with stocks, there’s the perception that the average consumer is much stronger than they really are. First, the labor market has been resilient. In the past, companies were much quicker to let go of employees. Post Covid, companies have been much more reluctant to let go of labor – and they’ve managed to do it without impacting margins much. The other big positive is that debt service ratios for most consumers are low on an historical level.
“Yet there are clearly some negatives. The excess savings that consumers had during the Covid years are pretty much gone. You’re starting to see credit card balances – which had gone way down during Covid – back up to pre-Covid levels. Anecdotally, we’re hearing from big retailers that consumers are starting to change their shopping habits, buying less expensive items. And sales of big ticket items are starting to decline. Finally, with mortgage rates above 8%, we’re seeing a decline in real estate transactions.
“We’re of the opinion that recessionary pre-conditions are in place. In the next three to six months, we’ll get a much clearer indication of the degree of the slowdown we’re likely to have.
“From a sector perspective, we’ve seen unhealthy concentrations in the benchmarks among some of the higher growth stocks. For example, the top five stocks in the S&P 500 are about 24% of the total – near an all-time high. I suspect they will stay in the 21%-24% range. The S&P 500 is showing the best cap weighted performance in 25 years, which makes me think that the equal weighted market is a much more attractive environment for active stock pickers.
“Over the next year, we expect to see a big pick-up in outperformance by active stock pickers as that market concentration stalls out.”
