When it comes to the relative strength of U.S. balance sheets, you’d be hard pressed to find a harsher critic than SocGen’s Andrew Lapthorne who, for quite some time, has been pounding the table on what he recently called “grotesque” corporate leverage.
“Leverage in the U.S. is grotesque for this stage of the cycle [and] at the moment you’ve got peak leverage at peak prices,” he mused, in a May interview with Bloomberg, adding that “it’s not like you have to dig deep to find a problem.”
Part of that “problem” is that corporate management teams have been incentivized to employ financial engineering in the service of inflating their bottom lines with buybacks amid record low borrowing costs. That penchant for recklessness is at least in part attributable to the perverse incentives created by equity-linked compensation and also to the “tyranny” of short-term thinking (i.e., a focus on the favorable optics that accompany bottom line quarterly beats).
Up until 2018, the market hasn’t been particularly keen on punishing that kind of behavior. In fact, as Goldman details in a note dated Friday, measures of leverage have become completely disconnected from relative equity performance (this is a point numerous analysts have made in one way or another over the past year as QE has effectively kept the cycle from turning). To wit:
Strong balance sheet stocks have historically outperformed weak balance sheet stocks during environments of rising leverage. This cycle, however, while net debt/EBITDA for the median S&P 500 company rose to the highest level on record, firms with weak balance sheets outperformed dramatically as investors rewarded firms capitalizing on historically accommodative monetary policy (Exhibit 2).
That’s obviously insane, but if you squint, you can see it turning around there at the bottom right-hand corner.
“Since January 2017, however, firms with strong balance sheets have outperformed [and] we expect this recent trend will continue as monetary policy normalizes,” the bank goes on to write.
This is a critical discussion. As financial conditions tighten, it’s reasonable to assume that the equity of companies with stronger balance sheets will outperform as rising rates and tighter conditions effectively represent the tide going out on corporate management teams that lack discipline. Remember, financial conditions have remained loose despite Fed hikes thanks to the dollar’s rough 2017 and the fact that 10Y yields nearly fell below 2% last September before the market finally began to price back in Trump’s fiscal agenda.
Here’s Goldman documenting the gradual tightening of their FCI and recommending an tilt to stronger balance sheet stocks:
We expect financial conditions will continue to tighten from record easy levels. The Goldman Sachs US Financial Conditions Index (FCI) shows that conditions have steadily tightened since reaching the easiest level on record in January. Since then, all five components of the FCI have contributed to tighter financial conditions: 10- year US Treasury yields have risen, the USD has strengthened, credit spreads have widened, equities have fallen, and the Fed delivered an interest rate hike at its March meeting.
In the equities market, tightening financial conditions should drive the continued outperformance of stocks with strong balance sheets (Exhibit 1). We have recommended investors own strong balance sheet stocks given the backdrop of record corporate leverage and Fed tightening.
The time to act on this is probably now (or better yet yesterday), because as you might have noticed, the lengthy reprieve that markets got from the assumed tightening that should accompany Fed hikes is over and unless the turmoil in EM or some other acute shock ends up delivering a truly harrowing collapse in DM equities, it doesn’t seem like Jerome Powell is going to be predisposed to deviating from the course the Fed has set.
Here’s Goldman one more time:
Looking further ahead, our economists’ expected Fed hike path is much more hawkish than futures market pricing. Futures pricing implies 2 additional hikes in 2018 and 2 hikes in 2019, below our economists’ forecast of 3 and 4 hikes, respectively. Further, our colleagues believe the risks to their forecast of 4 rate hikes in 2019 are skewed to the upside.