Credit Risk & Slowing Economic Growth
Credit risks have surrounded the dramatic rise in low-quality debt during this economic cycle. Low interest rates over the course of the cycle have spurred business borrowing, especially at the low end of the credit spectrum. These higher levels of debt now appear more ominous given a backdrop of slowing economic growth amid rising business costs (fueled mainly by higher wages and tariffs).
Economic growth is expected to slow in 2019 and again in 2020 as the boost from fiscal stimulus wanes and the negative effects from tariffs build. In a recent survey by Duke’s Fuqua School of Business, 69% of U.S. CFOs predicted a recession by the end of 2020.1 The same group cited difficulty in hiring and retaining qualified employees as their leading concern.
Where Credit Risk Lives In Equities
High yield and leveraged loan debt outstanding — on an absolute basis as well as relative to measures of cash flow generation – have surpassed all past peaks. Notable for equity investors is that lower-rated companies tend to be smaller in size. As such, it shouldn’t be a surprise that the net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization — a rough measure of cash flow) ratios for the S&P MidCap 400 and S&P SmallCap 600 indexes have risen to all-time highs. For comparison, by the same measure, the S&P 500 index remains near all-time lows (see accompanying chart).
Even more notable, in the event of a default, equity investors are the most at risk as they sit lowest in the capital structure. Yet the broad strokes of index-level analyses miss the underlying differences among the index constituents. While a large and growing contingent of companies have contributed to the higher ratio of net debt to EBITDA for the indexes, we believe there continues to be a large opportunity set of mid- and small-cap companies, ones either with no debt or which carry a reasonable amount of debt, for investors to consider.
The Small- & Mid-Cap Opportunity
We don’t see these high debt levels as a reason to avoid or underweight small- and mid-caps, only their representative indexes. We favor an emphasis on active management where there is the potential to mitigate these risks while maintaining the return and diversification benefits of these asset classes.
1 Duke CFO Global Business Outlook, “CRO Survey: Global Recession Predicted; Strong Support for U.S. Immigration Reform,” June 11, 2019.
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