Unearthing the overall credit profile of the U.S. equity market
From Standard & Poor's Equity ResearchThis matters because the U.S. economy, once again, is sending signals that recession may be inevitable. The August employment report showed the eighth-consecutive monthly decline in nonfarm payrolls, as the U.S. unemployment rate spiked to 6.1% from 5.7% in July. The August reading of the Institute for Supply Management's Purchasing Managers' Index was much more ambiguous than the August employment report when it comes to U.S. economic weakness. The August ISM PMI fell ever so slightly to a very neutral 49.9 from a perfectly neutral reading of 50 in July. The future direction of the ISM PMI is relevant to both the U.S. economy and underlying corporate credit conditions.
Standard & Poor's Market, Credit and Risk Strategies' goal was to provide a comparative framework for judging the risk/return profile for each of the 10 sectors of the S&P 1500 equity index over the last eight years where ratings data is available.
On average, there is a fairly consistent trend since 2000 for equities of moderate-risk A, BBB, and BB-rated companies to outperform either their higher investment-grade AAA-rated peers or their lower, speculative-grade B peers. Alpha-seeking equity investors have recently shown a preference for BBB and BB-rated companies during the post-2002 market cycle, which could prove to be problematic if the economy slips into prolonged recession.
Given the damage a sustained U.S. downturn would inflict on corporate profits and the potential for increased corporate defaults, investors at a minimum may want to monitor the overall credit-risk profile of their portfolios according to sector weightings as a starting point for investigating credit quality at the individual constituent level. Investors could theoretically achieve a more defensive sector-neutral equity posture by reallocating within any given sector from a stock with an associated BB issuer rating to a stock with a higher A issuer rating. Investors could also make the opposite decision once they conclude that the U.S. economic outlook is brightening.
We began by summarizing the average credit-rating risk profile, sector by sector, for the 844 corporations within the S&P 1500 for which Standard & Poor's has assigned long-term issuer credit ratings since January 2000. We structured our query to return data on companies with credit ratings falling between AAA and B, choosing to exclude the C-rated companies due to the small sample sizes and lack of consistent history returned among the 10 sectors.
The majority of the 10 sectors in the S&P 1500 equity index, where the constituents also have affiliated Standard & Poor's long-term issuer credit ratings, tend to have credit ratings falling somewhere between A and BB since 2000.
Credit ratings for consumer staples, financials, telecom, and utilities leaned toward the investment-grade categories of A and BBB, while consumer discretionary, energy, health care, industrials, materials, and information technology were weighted toward BBB and BB (i.e., both investment grade and speculative grade).
It is also interesting how "external factors" can have a transient effect on market-perceived credit risks relative to the long-standing ratings actions of credit analysts. For example, according to the profiles shown above, energy stocks have presented a relatively riskier credit profile, which with hindsight was in all likelihood somewhat overstated when gauged against the escalating price of crude oil and natural gas. On the other hand, the financials sector historically has been assigned a solid net investment-grade credit rating. But the reality of sharp declines in real estate valuations and rising mortgage delinquencies have dramatically altered market perceptions about the credit risks surrounding this sector.
The bull market in commodities has also been a supportive "external factor" for the materials sector, while the credit crunch has weighed heavily on the auto, retail, and homebuilding industries within the consumer discretionary sector. The second chart delineates the average balance within the S&P 1500 between investment-grade and speculative-grade companies since 2000 for the 10 sectors of the S&P 1500 where credit ratings data are available.
Multiple variables of unknown influence pertaining to the relationship between equity credit quality and performance come to mind after reviewing this report. First of all, the fact that shares of AAA and AA-rated companies underperformed those of lesser credit-quality companies, such as BBB and BB, is at least partially due, we think, to the fact that higher-quality, large-cap stocks, like the ones included in the S&P 500 index, were driven to egregious P/E multiples at the height of the "bubble" in the year 2000, the year in which our data in this study begin. Therefore, we think part of the reason for the AAA/AA large-cap underperformance was that these stocks had a much further distance from which to fall after the bubble burst.
Likewise, the outperformance over the last five-plus years of small-cap and mid-cap stocks during the excessively easy credit terms that existed until mid-year 2007 also helps explain why shares of lesser quality BBB and BB issuer-rated companies have done so well relative to comparatively higher-grade credits.
This brings us to the current day and the past year's progression from increasing subprime mortgage delinquencies, to financial sector credit crunch, to full-blown global credit contagion, a series of events that prompted market participants to rethink past assumptions about credit quality and credit risk.
This makes us believe that investors may now want to scrutinize the underlying constituent credit ratings within and between equity sectors when making strategic portfolio allocation decisions.