The Big Idea
Inflation, margins and credit
Steven Abrahams | November 12, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The market often trades as if inflation is a good thing for credit. Rising inflation expectations generally come with tighter credit spreads and falling expectations with wider spreads. That market intuition has to assume inflation will lift issuer revenues faster than costs and that the issuer will be able to pay off debt with inflated dollars. That definitely seems to be the case over the last few quarters, with both inflation and corporate margins surging. History, however, is a little more subtle.
Inflation and corporate margins historically do move in rough synch, but the magnitude depends on the particular margin. A few are important:
- Gross Margin: Revenue – Cost of Goods Sold (COGS) as a share of revenue
- Operating Margin: Revenue – COGS – G&A Expenses as a share of revenue
- Profit Margin: Revenue – COGS – G&A – Interest, Taxes, Depreciation and Amortization as a share of revenue
All corporate margins tend to fall going into recession and rebound in the aftermath (Exhibit 1). That was the case in 2001, 2008 and in 2020. Those clear patterns suggest the revenue side of the equation tends to move faster than the cost side. Declining demand initially lowers revenue faster than companies can reduce costs. Then rising demand after recession raises revenue faster than costs.
Exhibit 1: Inflation has a complicated relationship with business margins
A focus on particular margin tells an interesting story. Gross margin varies the least, especially as a percentage of its initial level. That is partly because gross margin is high, ranging for the S&P 500 since 2000 between 30% and 35%. But it is also because the cost of goods sold—reflecting inputs to making the product or service—varies more in parallel with revenue. Operating margin varies more than gross margin, partly because operating margin is lower, ranging between 8% and 15%. But operating margin also varies more because the cost side includes general and administrative expenses that are harder to adjust over short periods. Profit margin varies the most again because of scale, ranging between 1% and 12%. But profit margin also varies because it includes depreciation, amortization and other costs that are fixed, preventing management from offsetting lower revenues by cutting these costs.
For buyers of corporate debt, operating margin arguably is the most important one because it reflects net revenue before interest expense—in other words, the money available each period to pay debt. Quarterly changes in inflation and quarterly changes in operating margin are positively correlated, but quarterly inflation only explains around 5% of the quarterly variability in operating margin. That means other things—new products, new markets, new process, new technology and so on—explains the remaining 95% of margin.
Across different business sectors, the link between inflation and margin changes. Energy has the strongest correlation between inflation and operating margin, at one extreme, with real estate operating margin negatively correlated with inflation at the other extreme (Exhibit 2). That suggests the revenue line for energy moves the fastest among business sectors relative to costs, while the cost line for real estate moves faster than revenue. With real estate largely reflecting commercial property REITs, the long tenor of many commercial leases likely creates the slow revenue adjustment.
Exhibit 2: Operating margin in different sectors vary in response to inflation
The history of corporate margin and inflation does line up with the market intuition that inflation generally is a good thing for the ability of issuers to raise margin and repay debt. But the magnitude is small, and it varies across market sectors. It also surely varies across individual companies within a sector.
Although the headlines are full of concern about persistent inflation, the TIPS market continues to price for inflation that subsides. At that point, a positive correlation between inflation and margin works against credit. Inflation falls, and, all else equal, margin comes with it. Revenues stop accelerating, costs start to catch up. That’s part of market intuition, and it’s in the historical record, too.
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The view in rates
The Fed’s RRP facility is closing Friday with balances at $1.42 trillion. The facility posted its high mark on September 30 at $1.6 trillion, and with taper starting, the facility has likely seen its peak.
Settings on 3-month LIBOR have closed Friday at 15.438 bp, its highest level since mid-May. With taper and deceleration of liquidity, yields at the short end of the curve should start to rise.
The 10-year note has finished the most recent session at 1.56%, up 12 bp from a week ago. The 10-year real rate finished the week at negative 117 bp, down from negative 110 bp a week ago. The market continues to price for accelerating and significant excess liquidity in the future and an economy too slow to generate the borrowing needed to fully absorb it all.
The Treasury yield curve has finished its most recent session with 2s10s at 105 bp, unchanged on the week, and 5s30s at 71 bp, flatter by 12 bp on the week.
The view in spreads
The bullish case for credit and the bearish case for MBS continues, despite surprisingly tighter spreads in MBS. Corporate and structured credit has held spread through most of the year despite the steady approach of Fed tapering. MBS, on the other hand, generally widened from the end of May before starting to tighten after the September FOMC.
Corporates benefit from strong corporate fundamentals and buyers not tied to Fed policy. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand. Demand from Fed and banks should soften as taper begins, Once the Fed shows it hand on the timing and pace of taper, the market should be able to fully price the softening in Fed and bank demand and spreads should stabilize. But something else is on the horizon.
MBS stands to face a fundamental challenge in the next few months as the market starts to price the impact of higher Fannie Mae and Freddie Mac loan limits. Home prices are tracking toward a nearly 20% year-over-year gain, which should get reflected in new agency loan limits traditionally announced in late November for loan delivered starting January 1. The jump in loans balances should add significant negative convexity to the TBA market and increase net supply. And this will come just as the Fed leans into tapering, which will take out a buyer that often absorbed the most negatively convex pools from TBA and a large share of net supply. The quality of TBA should deteriorate and the supply swell.
The view in credit
Credit fundamentals continue to look strong. Initial earnings reports from the third quarter are still strong. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.
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