Corporate Health Indicators Signal an Economy in Transition
Our survey[i] on corporate health in the third quarter painted a picture of an economy in transition. Even as some key fundamentals showed a marked deterioration from the previous quarter, others, notably the outlook for corporate credit, displayed surprising resilience. Given the macro backdrop, we expect further weakness from here. Going forward, we will be focused on two critical questions. How much weaker could the US economy get and how much damage could that do to credit?
In the third quarter, pricing power and profit margins both registered significant declines, a conclusion drawn from the work of our credit analysts who closely follow more than two dozen industries and the work of our macro strategies research team.
In our view, a key driver in the equation is the erosion of pricing power. As costs continue to rise, companies are less able to pass those expenses on to their customers. Weakening pricing power can be a double-edged sword. Over time, it could lead to a welcome decline in inflation. In the short run, however, it has been eating into profit margins. Profit growth for the S&P 500 has steadily declined in the first three quarters of 2022.
Pockets of strength
At the same time, the survey revealed signs of stability in some measures of corporate health. Leverage appears at manageable levels, defaults are currently low and the credit outlook has weakened only slightly. The vast majority of our analysts still are quite sanguine about credit. Only a small minority reported declines in credit quality in their industries. Few anticipate a developing crisis. That resilience could be attributed to a point we have made in previous posts: this corporate falloff started from high levels. Profit margins for the Russell 3000® Index, which represents 98 percent of publicly-traded US equities, reached an all-time high in Q4 2021. Even as margins have compressed this year, they have been relatively high by historical standards.