A definition by the University of Oxford suggests that a cycle is “a series of events that are regularly repeated in the same order.” In the natural sciences, cycles follow certain patterns. The point in time, amplitude and degree of fluctuation repeat themselves. Economies, companies, markets and investor behaviour do not exhibit these fixed regularities. The movements are more complex and not predictable. They interlock, meaning that alongside the economic cycle there is the corporate profits cycle, the property market cycle, the general attitude toward risk amongst market players and other aspects, too. Together they provide the fundamental and the sentiment-driven framework data for investments in the capital market.
During recessions falling corporate profits are considered to be the reason for the weakness of the economy and share prices. That said, why in a recession do the profits of publicly listed companies fall disproportionately sharply if macroeconomic growth only deviates by a few percentage points from its long-term growth trend for a temporary period?
The answer at the corporate end relates to the scale of the leverage. A distinction must be made here between the operating and the financial leverage. The operating leverage refers to how strongly operating profits rise if company sales increase (and vice versa). Companies with high fixed costs and a low portion of variable costs have high operating leverage (examples are carmakers, hotels, airlines, cruise ship operators, car hire companies). As a result, these companies report far greater dents to profits in a recession than do crisis-proof food manufacturers or other “defensive” equities.
In the corporate world, there is also financial leverage. This results from taking up outside capital and entering into firm obligations to make interest and redemption payments. The owners of a successful company that requires funds do not perhaps wish to dilute their ownership of the company by floating additional equity capital. Instead, they take out loans. High financial leverage is an advantage if the company’s total ROCE exceeds net interest after tax. Unlike operating leverage, financial leverage is far easier to steer. In the past, US corporations were in particular often accused of ramping up financial leverage by using loans to disburse dividends to shareholders and buying back own shares.
In fact, debt carried by corporate America (excluding financial equities) has since 2010 risen by two thirds from USD 6 trillion to USD 10 trillion. In relation to gross domestic product (GDP), which has likewise increased, the debt ratio has now reached an all-time high of 47 percent; this does not seem fearfully high either by historical comparison or in relation to other industrialised nations. The last three US recessions – in 1990, 1999 and 2007 – were all preceded by similarly high debt levels. In a speech in early May Fed Chairman Powell bore out our assessment, although the Fed intends, along with other watchdogs, to take a closer look at leveraged loans going forwards, meaning secured loans that are speculative in nature. These have of late been more strongly the subject of debate.
If interest rates remain exceptionally low, then the burden companies have to shoulder to pay interest and service debt will in future also remain limited. Only in specific cases would today’s debt levels be a cause for concern. We think that today the majority of US and European companies have rather sustainable debt levels. Moreover, many of today’s growth drivers in the USA, including the major tech corporations such as Apple or Facebook, are largely able to self-finance their investments and require no outside capital. They thus have a safety cushion in the event of profits or interest rates changing for the worse. In general, the low interest rates have also spurred a trend toward longer-term loans. This shift away from short-term financing has rendered companies less prone to less favourable refinancing conditions.
Among the DAX-listed companies, various key ratios likewise confirm that their financing structure is sound. In 2018, for example, earnings before interest and taxes (excluding financial corporations) exceeded interest payments made by a factor of ten. The ratio of financial debt to equity on the balance sheet is also sound and runs at 44 percent, the lowest level in the period monitored since 2007.
Although balance sheets remain healthy, financial difficulties could swiftly arise if the negative effect of the above-mentioned operating leverage is too high. Often ostensibly small stimuli can suffice to trigger such a braking movement. In some sectors this can already happen if sales growth slows. In more recent times, namely in 2014-5, the price of crude oil crunched by three quarters and led to payment defaults on US bonds in the energy sector, also sparking bankruptcies. A new drag could be created by the ongoing strain of the US policy on customs tariffs. However, as long as interest rates remain so low, such individual sector trends are not to be expected to spill over and impact the equities market as a whole.