By John Lonski at Moody's
Volatility is king. Markets have been indifferent to claims that the latest broad sell-off of equities, lower quality corporate bonds, and certain emerging market currencies exaggerate any worsening of observable fundamentals. However, observable is the key adjective in the prior sentence. The two latest recessions were partly the consequence of markets not knowing the full extent of deteriorations in household and business credit quality. Not everything can be quantified, if only because some very critical things are hidden. Never underestimate the importance of thorough accounting. For now, it’s hard to imagine why the equity market will steady if the US high-yield bond spread remains wider than 800 bp. Taken together, the highest average EDF (expected default frequency) metric of US/Canadian non-investment-grade companies of the current recovery and its steepest three-month upturn since March 2009 favor an onerous high-yield bond spread of roughly 850 bp. Recently, the high-yield spread approximated 800 bp. (Figure 1.)
A wider-than 800 bp high-yield spread reflects elevated risk aversion that will reduce capital formation and spending by non-investment-grade businesses. In addition, ultra-wide bond yield spreads favor a continuation of equity market volatility that should sap the confidence of businesses and consumers.
M&A’s record pace may prompt more M&A-linked downgrades As derived from data supplied by Bloomberg, mergers and acquisitions (M&A) involving at least one US company soared higher by 19% annually to a new zenith of $3.336 trillion for yearlong 2015. A cresting by M&A may offer valuable insight regarding the state of the business cycle. The two previous yearlong peaks for US company M&A were set in Q3-2007 at $2.213 trillion and in Q1-2000 at $1.745 trillion. Recessions struck within one year of each of those peaks. Also, both previous peaks for M&A preceded a topping off of the quarter-long average for the market value of US common stock. (Figure 2.) For 2015, US-company M&A approximated 162.3% of pretax profits from current production and a record 18.6% of US GDP. The erstwhile record high ratio of M&A to GDP was the 17.8% of the year-ended Q1-2000. Year-end Q3-2000’s 215.1% still serves as the apex for the ratio of M&A to profits. During the early stages of an upturn by M&A, M&A-linked credit rating revisions show more upgrades than downgrades. For example, M&A-linked rating changes showed more upgrades than downgrades during 2010 through 2012, or after M&A activity had bottomed in 2009. However, M&A figured in more downgrades than upgrades once new record highs were set for M&A in 2000, 2007 and 2014. (Figure 3.)
Net downgrades linked to M&A rose from 2014’s 33 to 2015’s 36 as the increase in the number of relevant downgrades (from 89 to 114) eclipsed the rise in the number of related upgrades (from 56 to 78). In 2016, upgrades stemming from M&A are likely to decline, while downgrades hold steady or rise. A further decline by upgrades relative to downgrades for M&A-linked rating revisions would be consistent with an aging business cycle upturn. (Figure 4.)
M&A’s record pace for 2015 stemmed from comparatively low borrowing costs, a relatively stable equity market and diminished prospects for organic revenue growth. The importance of the latter helps to explain why record highs for M&A tend to occur close to the end of a business cycle upturn. The urge to merge will be greater the more convinced corporations are of the imperative to meet long-term earnings targets via mergers, acquisitions or divestitures. 2015’s downgrades from equity buybacks and dividends fell short of 2013’s cycle high In order to supply a more immediate lift to shareholder returns, corporations may buy back their own equity or boost dividends. A more uncertain earnings outlook will increase the incentive to return equity capital or profits to shareholders, as opposed to investing such funds in a company’s production capabilities. Sometimes, efforts to enhance shareholder returns trigger credit rating downgrades. Typically, strategies which benefit shareholders at the expense of creditors employ cash- or debt-funded equity buybacks and dividends. The number of US credit rating downgrades stemming from shareholder compensation increased for 2014’s 40 to 2015’s 48. However, the latter was less than 2013’s current cycle high of 59 and was well under 2007’s record high of 78. Fewer upgrades from external infusions of common equity capital Just as shareholder-compensation driven climbs by the ratio of debt capital to common-equity capital can lessen credit quality, reductions in the debt to equity ratio via infusions of common equity capital can improve credit standing. Additional common equity capital can be obtained from external sources via initial and secondary offerings of common stock, as well as from private-equity owners. After reaching a current cycle high of 43 in 2013, upgrades stemming from infusions of common equity capital subsequently eased to 2014’s 27 and 2015’s 18. The current upturn’s high for equity-infusion upgrades falls short of previous cycle highs of 53 from 2005 and 46 from 1996. (Figure 5.)
The difference between (i) upgrades stemming from infusions of common equity capital less (ii) shareholdercompensation driven downgrades tends to increase coming out of a recession and remains positive at least through the early stages of a business cycle upturn. Thereafter, shareholder-compensation downgrades exceed equity-infusion upgrades into the ensuing cycle downturn. The current upturn is unusual in that equity-infusion upgrades were less than shareholder compensation downgrades for an unprecedented fourth straight year in 2015 notwithstanding an accompanying 12.6% average annualized increase by the market value of US common stock. By contrast, when the market value of common equity soared higher by 18.2% annualized during the seven-years-ended 1999, equity-infusion upgrades topped shareholder-compensation downgrades in each year. Perhaps equity buybacks have supplied above-average lift to share prices during the current upturn. (Figure 6.)