Monday Morning Minute 041618
THE WEEK AHEAD
We look at how rising interest rates could harm returns for some highly-leveraged firms.
MACROECONOMIC INSIGHT
Some firm are paying more to borrow money, which is weighing on stock price performance.
The world’s most widely used benchmark for pricing loans and specifying financial contracts is the London Interbank Offered Rate, or LIBOR. The rate for 30-day LIBOR stands near 2.4%, about double the level of a year ago, and most of the rise occurred in the last four months (chart, below). Over $5 trillion of business and consumer loans reset relative to LIBOR, making this a key measure of the real cost of borrowed money. To show the performance of high-debt companies, we selected those S&P 500 companies with a greater than 50% debt to capital ratio. As the chart below and right shows, these companies have lagged behind the S&P 500 over the past year as rates rose.
In our view, high-debt loads can suddenly become a problem for some companies for two reasons.
First, debt creates a fixed cost that a company must pay regardless of how well, or poorly, the company’s business is performing. If debt becomes too great, and interest costs spike, the a sharp drop in profits becomes more likely, and the stock can suffer badly. As the financial crisis showed us, if business conditions also worsen, financial troubles for levered firms can easily and rapidly escalate without warning.
Higher interest costs can also hurt stock performance by reducing the present value of future cash flow. This is because the theoretical worth of a business is based on future cash flow discounted to the present day using an appropriate interest rate. When rates rise, the higher discount rate puts downward pressure on today’s value of a firm’s future prospects even if earnings projections remain strong.
Of course, the negative effects of debt are not always bad, and there are times when debt and leverage can convey benefits. When companies earn greater returns on borrowed money than what is paid to borrow the money in the first place, returns to equity holders are enhanced. The risk comes when too much debt meets rising interest rates and declining business conditions. Once the music stops playing, and rates rise or the business falters, risks can emerge suddenly and multiply rapidly. This is exactly what happened to dozens of august financial institutions during the teeth of the last recession.
But since the end of the crisis, businesses have enjoyed the benefits of very low interest rates. In the decade before the 2008-2009 financial crisis, many businesses borrowed short-term funds at rates in the 4-8% range. Since 2009, LIBOR has been close to zero which helped many firms generate easy profits. The improved economy and expected deficits ahead are leading to a ratcheting up of rates, reducing this advantage going forward. While low borrowing costs conveyed significant benefits in the first years of the expansion, high debt and leverage in portfolio companies today could lead to unwanted risk in portfolios.
Therefore, we believe an appropriate strategy today should center around balance sheet integrity, consistency of cash flow, and reasonable valuations. Chasing yield and leveraging return at this point in the cycle could expose portfolios to a higher degree of risk.
ECONOMIC DATA THIS WEEK
| Date | Report | Period | Survey | Prior |
| Monday, Apr 16: | Empire State Index | Apr | 18.0 | 22.5 |
| Retail Sales M/M | Mar | 0.4% | -0.1% | |
| Retail Sales ex Auto M/M | Mar | 0.25% | 0.2% | |
| Business Inventories M/M | Feb | 0.6% | 0.6% | |
| NAHB Housing Market Index | Apr | 69 | 70 | |
| Tuesday, Apr 17: | Housing Starts M/M | Mar | 2.6% | -7.0% |
| Building Permits M/M | Mar | 0.7% | -5.7% | |
| Industrial Production M/M | Mar | 0.3% | 0.95% | |
| Capacity Utilization M/M | Mar | 77.8% | 77.7% | |
| Wednesday, Apr 18: | Fed Beige Book | |||
| Thursday, Apr 19: | Weekly Jobless Claims | 4/14 | 230k | 233k |
| Philadelphia Fed Index | Apr | 21.0 | 22.3 | |
| Leading Indicators M/M | Mar | 0.35% | 0.60% | |
| Friday, Apr 20: | No Economic Data | |||
| Source: Bloomberg |
ASSET ALLOCATION PORTFOLIO POSTURE
Based on shorter-term expectations, the “tactical satellite” allocation within portfolios is:
Overweight Stocks vs. Bonds
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Suzanne Ashley, Analyst
(973) 549-4168
www.washingtoncrossingadvisors.com
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Disclosures
WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
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This commentary often expresses opinions about the direction of market, investment sector and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.
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