A lot of people are worried about corporate leverage. Years of cheap credit have encouraged corporate borrowing, and credit spreads have widened recently on fears of a global slowdown -- all of which makes for a potentially explosive cocktail. By one measure -- the debt-to-earnings ratio -- corporate leverage is at a 12-year high.
But other measures of corporate leverage suggest that fears of a corporate debt binge are overdone. According to Bloomberg data, the debt-to-Ebitda, debt-to-equity, and debt-to-assets ratios for the S&P 500 Index are all well below their historical averages since 1990. The U.S. is not alone. All three ratios for the MSCI ACWI ex-USA Index are also well below their historical averages since 1995 (for both the S&P 500 and ACWI ex-USA, the first year for which data is available).
Still, you can’t blame investors for being jumpy about leverage. Too much leverage has been blamed for some spectacular implosions, including Long Term Capital Management's flameout in the late ‘90s and, well, the entire world in 2008. As Warren Buffett likes to say, “Just about the only way a smart person can go broke is to borrow money.”
Modest leverage is also a lynchpin of corporate quality, along with high profitability and stable earnings -- and investors rightly look to corporate quality for protection during downturns. By these quality measures, investors appear to have little reason to fret. The debt-to-equity ratio for the S&P 500 is 1.1 compared to an historical average of 1.7; return on common equity (ROCE) is 12.6 percent compared to an historical average of 13 percent; and earnings volatility, as measured by the standard deviation of five-year trailing ROCE, is an astonishingly low 1.1 percent compared to an historical average of 4 percent.
Corporate quality is similarly reassuring overseas. The debt-to-equity ratio for the ACWI ex-USA is 1.4 compared to an historical average of 1.9; ROCE is 9.2 percent compared to an historical average of 9.3 percent; and here too earnings volatility is an astonishingly low 0.7 percent compared to an historical average of 3.7 percent.
When you add it all up, profitability has rarely been higher or more stable relative to corporate leverage both in the U.S. and overseas. The problem is that corporate quality is famously fleeting and whenever the next downturn comes it will undoubtedly ding quality. But I think investors who train their fears on corporate leverage are targeting the wrong thing.
Recent downturns are instructive. In the aftermath of the tech bubble bursting in the spring of 2000, ROCE for the S&P 500 dropped 84 percent (from 1999 to 2002), while earnings volatility increased sevenfold. By comparison, the debt-to-equity ratio rose a modest 14 percent. In other words, corporate quality deteriorated as one would expect, but the lion’s share of the blame for the deterioration of corporate quality went to profitability, not leverage.
Similarly, in the aftermath of the financial crisis that spilled into public view in the fall of 2008, ROCE sank 76 percent (from 2006 to 2008), while earnings volatility tripled. This time the debt-to-equity ratio declined 13 percent, providing a boost to otherwise deteriorating corporate quality.
Overseas markets tell a similar tale. ROCE for the ACWI ex-USA declined 70 percent from 2000 to 2002, but the debt-to-equity ratio budged a modest 13 percent. In the next downturn, ROCE declined 53 percent from 2007 to 2009, but just as it did in the U.S. during that period, the debt-to-equity ratio declined 16 percent (thus enhancing corporate quality even though profitability sagged).
If equity investors fear another global downturn, leverage should be the least of their worries. In historical terms, corporate leverage is modest today, and it has not been the driver of deteriorating corporate quality in recent downturns. On the other hand, profitability has been known to collapse and earnings volatility to spike when the going gets tough, and the U.S. in particular is due for a cyclical earnings correction.
So keep a close eye on profitability and don’t get distracted by leverage. Robust and stable earnings are where your bread is buttered.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in New York at firstname.lastname@example.org
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