SocGen’s Albert Edwards saw something this week he couldn’t believe.
“Normally when interest rates rise, so too do net debt payments, squeezing profit margins and slowing the economy,” he wrote, in a Thursday note.
That’s intuitive, but this time is different. No, really. It is. This time, corporate net interest payments “have instead collapsed,” as Albert put it.
So astonished was Edwards by the revelation that corporate interest payments as a share of post-tax profits have fallen amid the briskest rate-hiking campaign since he landed his first job in finance as an applied econometrician at the Bank of England in 1983, that he reached out to SocGen’s macro team for confirmation.
Sure enough, US corporate interest payments dropped dramatically of late. “Something very strange has happened,” Albert said. “And it helps explain the recession’s tardiness.”
The keen among you can probably conjure an explanation for this. Recall that IG and HY debt issuance exploded in the wake of the pandemic’s onset as the Fed stepped in to backstop corporate credit.
The door briefly slammed shut, then it was kicked wide open by Jerome Powell, who put a door stop in place, setting the stage for an explosion in primary market activity.
Corporates binge-borrowed, filling their coffers — you know, just in case the plague didn’t abate. High grade issuance was $1.82 trillion in 2020, and $1.4 trillion in 2021.
Thanks to long-maturity, fixed-rate debt, S&P 500 borrow costs (the ratio of interest expense to debt) hit a record low last year, shielding corporates from rising rates.
That was possible because corporates were able to fund spending with cash. Some of that cash was (and still is) generating sizable “profits” thanks to rising rates. “We have concluded that a sizable proportion of huge, fixed-rate borrowings during 2020/21 still survives on company balance sheets in variable rate deposits,” Edwards went on to say.
He continued: “Companies have effectively played the yield curve in reverse and become net beneficiaries of higher rates, adding 5% to profits over the last year instead of deducting 10%+ as usual,” he wrote.
So, it’s not just price hikes and “excuse-“/”greed”-flation driving up corporate profits. Another factor postponing the most widely-telegraphed recession in history is the absence of drag from interest payments.
Recall that corporate cash balances fell by the most on record in 2022 after surging the most ever. The figure below, from Goldman, speaks to that.
Going forward, and assuming rates do indeed stay some semblance of “higher for longer,” management will face harder choices.
But, it’s worth noting that more than 40% of S&P 500 debt outstanding (excluding financials) matures after 2030. So, even if companies do have to replace maturing debt with new borrowing at higher rates, it wouldn’t be a disaster, even if it would erode margins, all else equal.
Edwards summed it up. “Interest rates simply aren’t working as they once did,” he wrote. “It is indeed a mad, mad world.”
That is hugely explanatory.
common sense simple and says more than any ink i’ve seen (real or digital) on recession delayed (denied?).
This piece is finally the answer to “WTF is going on??” that I think most people have been wondering. So Trump handed out so much money that he basically disabled the Fed from being able to impact the economy for several years. Looking at the FRED data it looks like corporate interest payments have dropped by a whopping 452 Billion since Q1 2021 (You have to go back to 1984 to find such a low figure). Extrapolating from prior recessions going back 30 years, interest payments have typically spiked prior to the onset of a recession. So if this is the primary driver of the current growth cycle we’re sitting in, we have to wait for the payments to stop declining and grow enough to create a spike before the next recession occurs. Will the Fed hold interest rates high enough for long enough to force that to occur or is the soft landing actually achievable?
Also this graph throws some serious cold water on the blame higher wages for inflation narrative. Those increased wages aren’t even a rounding error on these interest savings.
I am a long term investor in UI ( formerly ubnt). I recently did the math to figure out the effect of refinancing existing debt ( currently at low interest rates) when it comes due a few years down the road. Most of the debt was used for share repurchases, and now, forecasted strong cash flow can be used to accelerate debt repayments between now and the date of debt refinancing. I don’t expect higher interest rates to be a problem at all in this situation because the amount of debt to be refinanced at maturity will be significantly below the existing debt balances.
I also wonder if some companies will partially replace debt with dilutive equity issuance- instead of refinancing. The math on this will vary by company.
Interesting post and comments. Makes you wish the US govt also loaded up on cheap LT debt when they could and never really understood why they did not, just like we continue to draw from the SPR despite oil prices being lower than anyone expected.
But I could see the opposite of what Emptynester has posited. Rather than using this buoyant market to issue equity and retire debt, it seems more likely that elevated buybacks will continue to deplete cash piles, and these reverse yield curve gains will give way to potentially large paper losses on those buybacks if the market ever does falter. Keep in mind that in 2022, the FAANG or whatever mega-group you wish to choose bought back huge amounts and were all sitting on giant paper losses on those purchases until this recent duration bounce.
Exactly. This might be a good time for me to partially pivot from SPY to individual stocks.
how do “experts” continuously get away with being surprised by things they should have known?
This is very interesting….It requires a lot of work these days to understand the underlying forces…
Like the consumer, corporations will eventually spend down their stimmies. As Albert mentions, 40% have a nice short to medium term setup with respect to their interest costs but the damage to the other 60% might be enough to cause some problems. If the Fed can’t get inflation back to target in the next couple of years what then? Corporates aren’t like homeowners, who, if forced, can stay in their mortgage and never move.