The Federal Reserve was expected to crush corporate profits and trigger a recession. Stephen Dover explains why that didn't happen.
The resilience of U.S. growth, earnings and markets has been the big surprise of 2023. Few expected that strength at the beginning of the year, as the Fed leaned into its campaign of rate increases. And yet the U.S. has so far avoided a recession, seen an upswing in U.S. corporate earnings expectations, and enjoyed a strong rebound of major equity indexes.
Those factors help explain why the U.S. economy and consumer spending have held up better than many thought they would at the onset of 2023. A strong labor market, underpinned by post-Covid rehiring, shortages of able-bodied workers, and fiscal stimulus have also contributed significantly to the resilience of demand.
One effect of these changes is to lengthen the time it takes for corporate debt-servicing costs to rise when the Fed increases interest rates. These structural changes in corporate finance have thus far sheltered the corporate sector from the harshest impacts of what has otherwise been an aggressive series of Fed rate hikes.
That is a contributing factor to explain why, for virtually every sector in the S&P 500 Index , net interest expense as a percentage of net profit is lower today than it was 20 years ago. Indeed, for the S&P 500 as a whole, net interest expense as a percentage of net profit is today only about 40% of its 2003 level.
But the corporate debt shield may yet endure for longer. That is because maturity extension has been significant for many companies and across many sectors. Since the end of 2020, for example, the proportion of investment-grade debt maturing after 2028 has gone from roughly 48% to 56%. This trend is even more pronounced among high yield borrowers. There, the proportion of borrowings extending beyond 2028 has risen from 20% to roughly 42% of the market.
If so, the resilience of earnings and growth has another key implication for investors—namely reduced default risk. Credit risk is more nuanced. Individual defaults remain possible, and some will be unavoidable. But barring a freezing up of lending markets, overall corporate default rates are likely to be lower in this cycle than in prior ones.
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