The ‘Music Of The Credit Cycle’ Will Keep Playing – Until It Stops

If you’re looking to capture the “essence” of the current cycle, you needn’t look much further than the explosion in non-financial corporate debt and the concurrent bid for equities from corporate management teams.

That’s the message one gets from a quick read of Oleg Melentyev’s base case for 2020.

Melentyev is BofA’s US high yield strategist. In a note dated Friday, he expresses a generally benign take on things headed into the new year. But that’s contingent on the somewhat dubious dynamics that have defined the post-crisis, easy money regime.

(BofA)

What you see there in the left pane is a $4.3 trillion corporate debt binge since 2009. In the right pane is a simple visual showing net buybacks.

“About 30% of total EPS growth in the last five years was derived from share buybacks alone”, Melentyev notes, adding that “this was the music of this credit cycle — to borrow cheaply and to turn around to improve the bottom line through either share repurchases or M&A”.

That’s gone on for longer than many critics believed was possible. Central banks have succeeded in prolonging the cycle, and the hunt for yield has ensured that markets remain forgiving for corporate borrowers across the credit spectrum.

“Our base case paints a relatively benign picture, underpinned by our belief that ongoing appetite for yield will continue to support the ability of corporations to use their balance sheets to improve their EPS numbers by repurchasing their own stock or buying growth assets elsewhere”,  Melentyev writes, summing up the base case, and adding that “as long as this delicate balance persists, the cycle is likely to keep on rolling and credit losses to remain manageable”.

Unfortunately, this has all been somewhat counterproductive for policymakers to the extent it prevents misallocated capital from being purged and thereby facilitates disinflation by encouraging overcapacity.

As far as what could go wrong next year, BofA’s high yield credit team zooms in on earnings.

The third quarter was widely expected to see the first contraction in US corporate bottom line growth in years, and that appears to be playing out, although not in dramatic fashion. But projections for a rebound in the coming quarters seem somewhat optimistic.

If you strip out the contribution from buybacks, “real” EPS growth is running around -2%, BofA notes, adding that bottom-up consensus is looking for profits to grow some 10% a year from now.

Melentyev is dubious. “We find it difficult to understand the sources of such an imminent turnaround in earnings”, he writes. “Our own estimate suggests that earnings are more likely to linger around current near-zero growth levels in a year from now, rather than grow double-digits”.

(BofA)

Uncertainty is rampant, something that’s readily apparent in CEO confidence, even as consumers continue to whistle past the proverbial graveyard (and that characterization assumes consumers aren’t correct to be sanguine).

The source of corporate consternation is readily apparent. We’re in the midst of a demonstrable downturn in global manufacturing precipitated by rampant geopolitical uncertainty and the seemingly intractable trade war. “The key element of this uncertainty could be traced back to the ongoing re-writing of trade agreements originating in the US and Europe around Brexit”, BofA says, noting that the result of that effort to reimagine the rules of global trade and commerce has been to create a giant question mark over “the future of cross-border flows of capital, goods, and services”.

If that uncertainty persists – and there’s every reason to believe it will, unless you’re inclined to think that the “Phase One” trade “deal” between Beijing and Donald Trump somehow clears everything up – one would imagine that corporate management teams will eventually decide that retrenchment on all fronts is preferable, especially given the prospect of an Elizabeth Warren presidency.

That retrenchment is precisely what Melentyev is concerned about.

“Such a backdrop increases the probability of a scenario where corporations could continue to tighten their spending and hiring plans in coming months and quarters”, he says, on the way to cautioning that “it is only going to take a few percentage points to be shaved off of the current modestly negative earnings growth for the psychological barriers to be broken, where consensus shifts away from describing this episode as a mid-cycle slowdown to something more meaningful”.

That’s the point of no return or, as he puts it, “once those barriers get broken they are difficult to restore”.