A sluggish batch of recent corporate earnings and growing debt levels are causing concern that cracks could be appearing in the decade-long bull market that has taken North American equities to record highs.
According to New York-based earnings tracker Refinitiv, profit growth has been slowing through 2019 to the point of flat-lining in the latest quarterly financial reports from companies listed on the S&P 500 and the S&P/TSX Composite Index.
The bulk of the decline can be attributed to a slumping energy sector and comparative double-digit growth in the third quarter of 2018, but the slump has gotten the attention of money managers.
“Earnings are still very resilient. Yes, we are seeing some signs of a slowdown in terms of the rate of growth over the past couple of years, but I don’t think that’s anything to panic about,” says Patrick Kim, co-founder and partner at Georgian Capital Partners Corp. in Toronto.
Quarterly financial statements generally come under scrutiny during earnings season, but Mr. Kim says corporate balance sheets, which provide a snapshot of a company’s current financial health, could be showing signs of stress as a decade of rock-bottom interest rates have enticed companies to increase borrowing. In many cases, they did it to repurchase outstanding shares to boost stock prices.
“It’s a growing concern over the increase in how much corporate debt has been issued,” he says.
Mr. Kim points to rising ratios that measure a company’s debt capacity, such as debt-to-equity and debt-to-EBITDA (earnings before interest, taxes depreciation and amortization).
“You’re seeing some of those numbers creep up,” he says.
As a result, he’s avoiding high-leveraged companies in struggling sectors such as energy.
“Energy companies are already seeing their revenue come under pressure, especially in Canada. They have tapped the debt markets as they traditionally have, and that’s something that’s just going to continue to put pressure on them,” he says.
Benchmark interest rates from central banks such as the U.S. Federal Reserve Board and the Bank of Canada have essentially been capped for the time being, but Mr. Kim says higher borrowing costs are a looming vulnerability for overleveraged companies.
“At some point, interest rates eventually have to go up. Maybe not this quarter, maybe not next quarter, but eventually,” he says.
Stephanie Douglas, partner and portfolio manager at Toronto-based Harris Douglas Asset Management Inc., is also paying close attention to debt levels on corporate balance sheets this earnings season.
“We’re looking for companies that have very low debt levels. They’re not using debt too aggressively to buy back shares,” she says.
Although her outlook for the global economy is positive, she says companies with too much debt on their books will have to shoulder the added cost burden as revenue declines.
“You don’t want to own those companies going into a slower growth economy,” she says.
Ms. Douglas’s debt concerns focus specifically on companies such as Caterpillar Inc. (CAT-N) in the manufacturing sector, which has been experiencing a slowdown according the latest data from the United States.
She’s also keeping a close eye on one of her core holdings, Canadian National Railway Co. (CNR-T), as a bellwether for signs of a slowing economy.
“CNR met expectations, but it did reduced its guidance. I wouldn’t say it’s a red flag but it does show the general health of the economy,” she says. “All the goods that are shipped by rail really reflect on the health of the economy.”
Nicholas Kraemer, head of ratings performance analytics at New York-based S&P Global Ratings, has been keeping tabs on rising debt levels among “BBB”-rated issuers, which comprise most of companies listed on the S&P 500 and S&P/TSX Composite Index. He says balance sheet debt for non-financial companies globally has risen by 171 per cent to almost US$3-trillion since 2007.
“[Debt levels are] high – very high. It’s unfair to not call attention or at least be sensitive to it,” he says.
S&P Global Ratings data show the sectors taking on the most debt over the past decade are real estate, utilities and transportation.
Regardless of the sector, Mr. Kraemer says all companies with high debt levels are vulnerable to slower growth and higher interest rates. Although most money managers focus on earnings statements, he tracks corporate debt and worries that debt-motivated downgrades to speculative-grade issues could shock the bond market.
“It’s a big population of issuers,” he says. “They’ve been issuing a lot of debt over the past few years and the main concern is whether the speculative market can absorb it?”
Mr. Kraemer doesn’t see an apparent trigger to cause that shock and says that central-bank interest rate moves are generally slow to affect corporate bond rates. And after three consecutive rate cuts from the Fed this year, he says the benchmark rate remains in a historically low 1.5-per-cent to 1.75-per-cent range, leaving plenty of time for overleveraged corporations to reduce their debt.
“It’s still low and now that we’re heading into a lower interest rate environment still, it does allow these companies to lever up,” he says.