How Much Are Continued Low Interest Rates Boosting Corporate Profits?
Reuters recently published an article, “How much is Fed aid to U.S. corporate profits worth?” which raised some interesting issues worth discussing. The piece made some useful points but also committed some serious errors. Below are the highlights of the article followed by my thoughts.
Many on Wall Street believe the Federal Reserve's monetary policy is behind record corporate earnings and the stock market's surge to all-time highs this year.
But how much is a burning issue for investors who wonder how the economy and stocks will perform once the Fed eventually eases its buying of $85 billion a month in bonds and eventually allows short-term rates to climb.
Some believe the influence of the Fed's policy, known as quantitative easing, has been particularly important to the performance of the benchmark Standard & Poor's 500 Index .SPX.
"People underestimate the extent to which quantitative easing has benefited the S&P," said Robbert van Batenburg, director of market strategy at brokerage Newedge USA LLC in New York. He called the effect akin to "an athlete on steroids."
The Fed's effect on corporate earnings is difficult to quantify. Van Batenburg estimates that corporate savings on interest expense after rates fell to historic lows has accounted for about 47 percent of S&P 500 earnings growth since 2009.
At the end of 2009, quarterly earnings per share for the S&P 500 were less than $20, and companies in the index paid about $4 a share in interest, van Batenburg said. Now the S&P 500 is generating about $26.70 a share in quarterly earnings but pays just $1.50 a share in interest.
Investors fear profitability could be hit hard when the program is reversed and rates eventually rise.
"Then the argument becomes, if interest rates normalize we're going to have to dial back that clock. Are we going to see a pullback in earnings?" van Batenburg said…
A look at rates suggests why earnings have more than tripled since 2000. The federal funds rate, the rate banks pay on overnight loans, was at 4.50 percent in late 2007. It was sharply reduced and now sits virtually at zero.
Long-term rates followed, falling from more than 5 percent in 2007 to record lows of about 1.4 percent in mid-2012. The 10-year U.S. Treasury yield was below 2 percent until late May.
David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates in Toronto, estimated in March that lower interest expense and corporate tax benefits have added about $30 a share to S&P 500 operating earnings.
Interest paid by U.S. businesses peaked in 2007 at $2.83 trillion, falling sharply from there to $1.34 trillion in 2011, the last year data is available, according to the St. Louis Fed…
"The result is that corporate America has seen a substantial decline in its cost of capital and it has greatly benefited its bottom line," van Batenburg said.
Higher borrowing costs aren't likely to bite in the near-term. Companies used the last few years to shift their debt loads further into the future, according to Morgan Stanley.
In December 2011, the heaviest volume of corporate loans was set to mature in 2014, 2016 and 2017. As of this June, most loans now mature in 2017, 2018 and 2019.
Not everyone believes the Fed is behind the profit surge.
"The real pickle here is that there is no way of knowing what interest rates would have been without Fed intervention," said Russell Price, senior economist at Ameriprise Financial Services Inc in Troy, Michigan.
Price believes earnings have benefited more from tax credits for research and development and favorable amortization and depreciation schedules. Corporate taxes paid to the federal government as a percentage of GDP has hovered around 1 percent since 2009, from more than 2 percent the prior four years.
Even though borrowing costs are down and net profit margins are at all-time highs, operating profitability has been falling. This suggests other factors have been eating into earnings.
Known as EBITDA margin, or earnings before interest, tax, depreciation and amortization divided by total revenue, operating profitability peaked at 25.6 percent in late 2007 and recently fell below 20 percent.
But margins tell only one part of the story. Richard Bernstein, the former long-time investment strategist at Merrill Lynch, noted that in 1981 and 1982, margins peaked, and then fell through the entire bull market of that decade.
"I don't think history supports the notion that margin compression equates to bear markets," said Bernstein, who now runs his own asset management firm, Richard Bernstein Advisors.
Stronger economic growth would also offset concerns about higher rates.
The history of recent rate-tightening periods suggests profits hold up reasonably well, Ameriprise's Price said.
In four defined periods of Fed tightening since 1985, all but one - the mid-1990s - preceded a recession. During those times, the Fed raised the fed funds rate by almost 300 basis points, on average. The market's performance was mixed, while the price-to-earnings ratio of companies in the S&P 500 index declined by 2 percent or a bit more, Price said.
In two of those periods - late 1987 to mid-1989 and from 2004 onward, profit growth remained strong. In the mid-1990s, profit growth strengthened. From late 1999 through 2000, profits initially grew but then slowed abruptly.
What differs this time is the unprecedented level of monetary stimulus that lowered borrowing costs. The yield on the Barclays US Corporate High Yield Index, a measurement of borrowing costs for junk-rated companies, fell below 5 percent in May for the first time in the index's 30-year history; it now sits at 5.82 percent.
Investors remain leery of higher rates. About two dozen S&P companies, not including financials and utilities, have debt levels exceeding 65 percent of their market value. Those stocks have underperformed since May 21, when the Fed started to talk about reducing bond purchases.
Conversely, for the first six months of 2013, the best metric for picking stocks was free cash flow yield, according to Morgan Stanley, indicating investors favor companies that can return some of their earnings in dividends, share buybacks or can reduce their debt.
How the market reacts to tightening is hard to judge, Price said. "Traders think it's going to be a negative, but investors may not likely think the same," he said.
Low interest rates are generally better for businesses. But, this article makes the mistake of equating the Federal Funds rate and longer-term Treasury rates with the interest rates at which corporations are borrowing.
Some of the analysts cited in the first part of the article then erroneously state that a large portion of the increased corporate profits are solely caused by artificially lowered Fed interest rates and that the economy and stock market will tank as soon as the Fed aid goes away and interest rates rise.
Like too many journalists, this piece was written with the thinking that you should interview numerous “experts” yet there is no basis for evaluating and vetting these folks. As a result, experts are quoted despite the fact that their track record with predictions is poor.
The quoting of David Rosenberg is a case in point. Rosenberg asserts that corporate profits during this multi-year recovery were boosted substantially by low interest rates and corporate tax benefits. This is a classic case of sour grapes because Rosenberg has never accepted that we’d have a recovery.
Like Nouriel Roubini, Rosenberg is a pundit whose predictions have been awful. After the severe recession, Rosenberg repeatedly called for a double-dip recession (which didn’t happen) and then like Paul Krugman, in 2010 Rosenberg said that we were in a depression (wrong again).
The best part of the article comes at the end when then author discusses prior periods of Fed tightening and the fact that corporate profits didn’t necessarily erode in the aftermath.
I have written numerous articles on the misunderstandings and misconceptions concerning quantitative easing. Please see those for more information.