Corporate Health is On the Mend, Powered by Manufacturing

We believe corporate health is on the mend. The latest results from the CANDIs,[i] proprietary diffusion indices that incorporate the views of our corporate credit analysts, indicate that aggregate corporate health is broadly improving and approaching neutral levels. Our analysts currently see positive trends in pricing power, profit margins, and their overall outlook, up from weak levels six months ago. Credit risk metrics like leverage have also improved. Despite the positive trajectory, we believe caution is still warranted. We see signals that the US corporate earnings recession could be ending, but tighter financial conditions are likely to slow economic growth. Read on for more on the CANDIs’ findings and our key takeaways for corporate health.

An uneven economy

The CANDIs’ recent readings show a disconnect between manufacturing and services companies. Manufacturing, which was the weakest area of the economy in the CANDIs’ early 2023 readings, has broadly improved since then. This shift is consistent with the ISM Manufacturing Index, which has risen for three consecutive months. Our analysts anticipate lower supply costs, stable leverage and an improving outlook for manufacturing industries over the next 6 months. Services, which make up a greater share of the US economy, have shown some improvement but currently lag manufacturing. The difference is particularly stark when it comes to supply costs. While our analysts anticipate lower supply costs in manufacturing, they expect higher supply costs in services, particularly in media, telecom and transportation-related industries. We will be watching services closely, as continued lagging could hold back economic growth in the US, even if manufacturing reaccelerates.

Pricing power kicking back in

The CANDIs’ output reveals that pricing power, a gauge of companies’ ability to pass on costs to consumers, has climbed higher for three consecutive quarters. The level remains below the neutral threshold, which suggests the majority of companies are still struggling to gain pricing power. However, we believe the positive trend can continue due to lower supply costs, particularly in manufacturing. We believe pricing power will be a key metric to watch going forward as inflation may become stickier if more companies begin passing costs onto consumers.

Pressure on profit margins finally easing?

Pricing power tends to be an indicator for profit margins. When companies can’t pass rising expenses on to consumers, they typically eat into profit margins. Our latest CANDIs reading shows a slight move higher in profit margins, consistent with the uptick in pricing power, but margins remain at depressed levels. Our analysts report some dispersion among industries, with manufacturing industries showing the most improvement.

S&P 500 profit margins[ii] seem to echo the CANDIs’ signals. Large-cap margins have generally been under pressure for several quarters as many companies contend with wage pressure, less demand and higher interest costs. Despite the decline, S&P 500 margins remain above most prior-cycle highs and appear to be in decent shape. We think it’s too early to say margins have bottomed, but we see the latest CANDIs reading as a sign of positive momentum.

A cautious outlook

We are encouraged by signs of improvement in corporate health, but weak fundamentals are keeping our outlook cautious. Acute downside risks seem to have abated for now. Going forward, we believe pricing power and profit margins will be key drivers of corporate health. If pricing power reaches the point where most companies are passing costs through to the consumer, we could see margins start to expand, prolonging the cycle. That’s our upside scenario, which assumes consumer health also holds up.

On the downside, as we mentioned earlier, more pricing power could bring on higher inflation as costs feed through to consumer prices. If inflation stays stickier than the Federal Reserve would like, it could lead to a higher-for-longer stance with another round of tightening financial conditions. We believe this scenario brings greater risk of a downturn, particularly if margin improvement stalls out and services companies turn to layoffs as a cost-cutting measure.

[i] Loomis Sayles’ Credit Analyst Diffusion Indices (CANDIs) are proprietary survey-based diffusion indices that draw from the work of Loomis Sayles’ credit research analysts, who follow more than two dozen industries. The CANDIS’ output can be an indicator of how key corporate health metrics may trend over the next six months. 

[ii] Source: Factset, as of 30 September 2023.

MALR032013

Market conditions are extremely fluid and change frequently.