28 May 2019

“Still Selling Lemonade”—1Q19 Earnings Show Resilience of Credit Cycle

By Kurt Halvorson

Over the past 18 months, investors in the US credit markets have faced a variety of dark clouds as they attempt to navigate this new age of headline driven volatility. Fears stemming from Brexit, the political situation in Italy, the trade war with China and the rate hiking cycle here in the US have all caused investor angst. Another such fear is about the length of the credit cycle and possibility of a recession—and we’re asked about this a lot. Given the volatility we saw in 4Q18, investors were once again predicting a material pullback in the US economy. However, 1Q19 GDP revealed a solid surprise to the upside and corporate fundamentals continue to show remarkable resilience.

With 95% of the S&P 500 having reported 1Q19 earnings, top-line growth continues to be strong and overall sales are trending up 5.3% YoY. In fact, of all the subsectors within the S&P 500, the only one that showed lower YoY revenues was technology (-1.2%), a sector that we have previously argued should be approached with a healthy dose of caution from the credit side. Financials (+11.5%) and consumer-related sectors (+8.4%), the main drivers of our economy, are still delivering robust growth. The tailwinds from tax reform and deregulation have proven to be a powerful force.

To be clear, the pace of growth has slowed, and this is to be expected as the economy responds to a rate hiking cycle. However, we’re now nine rate hikes in and the economy is still delivering strong top-line growth, which is a testament to its underlying strength. The key factors to watch going forward will be the behavior of the consumer as well as the impact from the unresolved issues of trade. Citigroup Research states, “A review of recent public remarks made by executives of more than two dozen large US companies reveals that US companies from a variety of sectors are prepared to defend profit margins through higher end-user prices, to the extent competitive pressure allows.” This will be a critical development to watch in the remainder of 2019 as it could lead to headwinds for the consumer, margin pressure for corporate America or perhaps both.

Attempting to predict the turn of this credit cycle has proven to be a losing game. Our base case has always been that this credit cycle would last much longer than previous cycles due to the depth of the pain felt during the great financial crisis and the lessons learned therein. Indeed, in this regard the economy continues to show no concept of time. Our strategy remains the same: as long as we see strength in the economy’s underlying fundamentals and corporate America continues to “sell more lemonade,” we will use pockets of volatility to add exposure to our core holdings and remain invested in this economic expansion.