Corporate Health Stabilizes, but We Expect More Weakness Ahead

After falling steadily for most of the past year, our latest quarterly survey of Loomis Sayles’ credit analysts revealed that two key measures of corporate health, pricing power and margins, showed signs of stabilizing in the first quarter of 2023. Inflation ticked down as well. But we think the hints of better news should be kept in perspective. Our credit analysts, who track 28 different industries, expect further deterioration ahead in pricing power, margins and credit quality. In six industries, including financials, our analysts see the risk of a crisis trending higher. A profits recession, which could trigger layoffs, is a distinct possibility in the months ahead. In short, we don’t think we’ve seen the bottom yet in corporate fundamentals.

Why pricing power matters

We have emphasized the importance of weakening pricing power in past reports. When firms can’t pass on rising costs to their customers, two things tend to happen: profit margins come down and so does inflation. We have seen evidence of both. Inflation has diminished but remains far above the Federal Reserve’s 2% target. Margins have come down too, yet because they started their decline from lofty levels, they remain respectable by historical standards. Defaults are still infrequent.

Some of our key observations

We think it is worth drilling down into a few key areas to better understand where corporate health stands now and where it might be heading.

• There is currently a big gap in the performance of the service and manufacturing sectors. Services have shown real resilience, in our view. In the first quarter, our analysts indicated improving expectations for services’ profit margins, while their expectations for manufacturing margins fell substantially. The latest ISM reports confirm our observations. Services expanded in February, while manufacturing activity fell to the lowest level since May 2020.
  
  

• The corporate health outlook appears to be darkening. Each quarter, we ask our analysts where they see trends heading for pricing power, margins, credit outlook and leverage, which we define as the ratio of debt to profits. For all four metrics, the number of analysts who expect further deterioration was greater than those looking for improvement. Our global macro strategies team is forecasting a mild profits recession for the S&P 500 Index for 2023.
• The potential for a crisis appears to be rising in a handful of industries. We asked our analysts whether the odds of a crisis are currently rising, falling or unchanged in the industries they cover. We don’t find it surprising that our analysts indicated a higher risk of crisis in six industries—energy, media, railroads, REITs, technology and US banks. Banks experienced a brief moment of distress following the well-publicized failure of Silicon Valley Bank. For the moment, the damage appears to be contained. It’s also worth noting that the vast majority of our analysts do not see elevated crisis risk in their industries.

Navigating the path forward

While the stabilization we saw in the first quarter was welcome, we view it as a respite in the process of deterioration, not an end point. If the economy continues to weaken and profits move lower, the remaining pillars of strength—job growth and wage growth—are likely to erode as well. There were slight hints of that in the March employment report—year-on-year wage growth was the lowest since June 2021[i]—but the Fed may want to see more softness before pausing its program of rate hikes.

In our view, the Fed’s final battle will be fought on the services inflation front, where the tightness of the labor market and wage growth are critical elements. The sooner the Fed stops hiking, the better it will likely be for markets and corporate health. Stubborn inflation and additional rate hikes typically increase the odds of recession.

Because companies generally entered the late stage of the credit cycle in good shape—with high profits and low leverage—we believe they are well-positioned to weather a mild downturn. In our view, downgrades and defaults are likely to pick up, but not spike. However, a more serious downturn could do more damage to corporate health.

[i] Source: Bureau of Labor Statistics.

MALR030816

Markets are extremely fluid and change frequently.