Corporate Credit, Employment And Recessions – Putting It All Together


Investment-grade corporate bonds have been a major tailwind to the economic cycle as yields continue to drop.

Treasury bond yields are falling faster than IG spreads are widening, resulting in lower borrowing costs, but a major increase in late 2018 may have triggered a change in employment.

A rise in corporate bond yields impacts cash flows, margins and, eventually, employment decisions.

Corporate bond prices (yields) are a long leading indicator that impacts the economic cycle through changes in corporate capital spending and employment.

The corporate sector is more leveraged than previous economic cycles. A recession can be triggered if the Coronavirus outbreak causes corporate rates to rise, accelerating the decline in employment growth.

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Along with money supply, building permits and corporate margins, corporate bond prices or corporate bond yields fall into the “long leading” indicator bucket, according to “the father of leading indicators,” Geoffrey Moore. Geoffrey Moore’s work found value in using the Dow Jones Corporate Bond Price Index (graphed below), but any measure of corporate bond yields will likely yield similar results. If using bond yields rather than bond prices, the indicator should be inverted as higher corporate bond yields usually translate to lower profit margins and slowing employment growth.

Dow Jones Corporate Bond Price Index:

Source: Bloomberg, EPB Macro Research

As the chart clearly shows, lead times before a recession can be quite long while lead times for recovery are more abrupt. The recovery (or suddenly lower corporate bond yields) has historically been quite helpful in restarting the hiring process and capital spending process.

From an economic cycle sequence perspective, lower bond prices or higher corporate bond yields reduce margins/profitability and have a resulting impact on the rate of capital spending and employment plans. The drop in capex and reduction in employment growth is what ultimately leads to lower income growth, consumption growth, and, eventually, a recession.

In Lacy Hunt’s most recent Quarterly Review and Outlook, he outlined Milton Friedman’s work, which explains that monetary changes (interest rates) and economic cycle impacts typically cluster around two years.

As the research of Nobel Laureate Milton Friedman documented, the typical lags between monetary change and economic fluctuations cluster around two years, confirming the importance of the two-year time frame.

A change in interest rates today may impact future projects. Still, existing investments will likely continue, resulting in a lag between the change in interest rates and the impact on more coincident economic data such as employment.

As a result of this finding, when studying interest rates, it can be valuable to use a 24-month change formula rather than a year-over-year method to more closely capture the two-year cluster.

The last point to stress before highlighting some of the more recent trends is that the level of corporate debt is at a record high relative to GDP.

Corporate Debt to GDP Ratio:

Source: Bloomberg, EPB Macro Research

Thus, similar to federal debt, there are diminishing marginal returns or reduced efficacy of each new dollar of debt. More importantly, however, smaller changes in interest rates (corporate bond prices) can have a similar or larger impact on corporate health and the resulting repercussions on overall employment.

Throughout the rest of this note, we will look at the impact of changes in corporate bond prices (yields) and the lagged relationship to employment, as well as some considerations when making a recession forecast.

Currently, corporate bond yields are still falling because Treasury rates are declining faster than spreads are widening. Lower corporate bond yields are helpful on the margin, but the late 2018 spike (two-year cluster) may have been enough to start the process of reduced employment, something very evident in recent data. If the Coronavirus outbreak causes corporate bond yields to rise and accelerates the existing decline in employment growth, a recession is very much in the cards.

Today’s rate of employment growth is insufficient to trigger a recession based on past samples. Still, when an existing downward trend is coupled with a negative shock, recession risk must remain firmly on the table.

US Corporate Sector Health Heading Into 2018

Corporate America has been plagued by anemic economic growth in this economic cycle. Masked by the rising share price of roughly 500 companies, thousands of corporations that aren’t publicly traded have been forced to operate in a low-profit growth regime.

Financial engineering has allowed publicly-traded companies to report strong earnings growth. Total corporate profits reported in the GDP report is a far more accurate, albeit delayed, data source on the real (non-adjusted) profits generated by the corporate sector.

From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.

Corporate Profits:

Source: Bloomberg, EPB Macro Research

On a five-year annualized basis, corporate profits have increased by just 2.2% with the latest year-over-year reading falling 0.3%.

Amazingly, corporate debt has increased, and share prices have soared with very little profit growth, a phenomenon exposed by persistently lower Treasury rates.

Corporate Profits Growth:

Source: Bloomberg, EPB Macro Research

Stacking together real estate debt, corporate debt, and consumer debt shows that the largest increase across economic cycles is coming from the corporate sector.

In the last economic cycle, corporate debt was only 25% of the credit market. In 2018, corporate credit increased to 38% of the total.

Corporate Sector Debt As A % of Total:

Source: Morgan Stanley, EPB Macro Research

As a result of lower profits and more debt, the leverage ratio in corporate America has surged to recessionary levels.

Importantly, the leverage ratio usually increases during a recession as profits (the denominator) fall. Morgan Stanley’s research from 2018 calls out that leverage is at an all-time high in a “healthy economy,” which highlights just how leveraged and sensitive to changes in interest rates the corporate sector has become.

Corporate Sector Leverage:

Source: Morgan Stanley, EPB Macro Research

When corporate borrowing costs rise, employment typically suffers as the increase in interest expense compresses margins.

Again, due to weak economic growth and lackluster profit growth across the entire corporate sector, margins (proxied below) have been compressing since the early stages of this economic cycle.

Lower margins foreshadow weaker employment growth and capital spending growth.

Corporate Margins:

Source: Bloomberg, EPB Macro Research

With corporate leverage at extreme levels and corporate margins already in decline, the corporate sector was particularly vulnerable to any spike in corporate borrowing costs as a result of an economic slowdown.

When the Federal Reserve embarked on a monetary tightening cycle, economic conditions globally started to deteriorate with a lag, hitting most economies in 2018 and 2019.

US corporate borrowing costs surged in late 2018 and early 2019, which triggered a more aggressive decline in employment growth and persistent weakness in capital spending growth.

Late 2018 Credit Event – Enough To Trigger A Recession?

Typically, before recessions, corporate bond prices decline (yields increase) as the Federal Reserve is raising interest rates, and the tighter monetary conditions eventually slow the economy, leading to wider corporate bond spreads.

Corporate bond prices declined three other times this economic cycle, coinciding with the three economic slowdowns before the current downturn.

The 2018 decline in corporate bond prices was larger than the previous three, a sign that economic conditions would weaken. When comparing to the past two recessionary samples, the decline in 2018 was marginally weaker than in 1999. Still, given the leverage ratio and decline in margins, a smaller decline could have a similar impact.

Corporate Bond Prices Tumble:

Source: Bloomberg, EPB Macro Research

Graphed another way, the chart below shows the 24-month change in Baa corporate bond yields.

The chart is graphed by the number of months before/after a recession with 0 on the x-axis indicating the start of a recession.

The 2018 rise in corporate bond yields was undoubtedly less than the previous three samples, only spending 14 months above 0% on a 24-month change.

Corporate Bond Yield 24-Month Change:

Source: Bloomberg, EPB Macro Research

The corporate sector is far more levered today, with weaker margins and lower trend growth as compared to the prior three recessions.

Thus it remains possible that the decline in corporate bond prices was enough to trigger a downshift in employment growth, an effort to preserve margins.

Impact On The Real Economy

Cycles in employment can be monitored separately from cycles in growth. Geoffrey Moore tracked cycles in growth, inflation, and jobs independently.

Leading indicators of economic growth turned lower very early in 2018, some in late 2017. Inflation indicators did not plunge until September 2018, and jobs growth did not inflect lower until corporate bond yields spiked in late 2018.

Cyclical employment, defined in the chart below as durable goods manufacturing, construction, and trade/transportation services, started to show rapidly-declining rates of growth.

Employment Growth Changed:

Source: Bloomberg, EPB Macro Research

If we track the change in cyclical employment growth before the three previous recessions, we can see recessionary periods begin with similar declines in cyclical employment.

Today’s current track of cyclical employment growth is currently insufficient to be recessionary based on past samples. However, if the trajectory does not flatten or inflect higher, history suggests that income and consumption growth will follow, leading to recessionary conditions.

Employment Growth Trend Relative To Past Samples:

Source: Bloomberg, EPB Macro Research

Employment growth over the next six months remains critical. If corporations continue to post weaker rates of employment growth or accelerate layoffs as a result of the Coronavirus outbreak, a recession is still firmly in play.

An existing trend of weaker growth and employment, originated by the Federal Reserve tightening cycle and deleveraging in China, exposed the economy to a negative shock.

It’s clear using the chart above how a negative shock (COVID-2019) coupled with an existing downturn in growth/employment can create a recession.

The Current Shock

The current economic shock has resulted in a widening of corporate bond spreads. Using popular credit ETFs (LQD) and (HYG), we can track the implied spread above Treasury bonds. Both investment-grade and high-yield credit spreads, particularly high yield, have been widening materially in the past several weeks.

Investment-Grade / High-Yield Corporate Spreads:

Source: Bloomberg, EPB Macro Research

Luckily, however, corporate yields are a function of Treasury rates plus a spread.

For investment-grade bonds, Treasury rates are still declining faster than spreads are increasing, resulting in lower investment-grade bond yields.

High-yield bonds, however, are starting to see higher yields, a firm negative for corporate margins and future employment.

Investment-Grade / High-Yield Corporate Bond Yields:

Source: Bloomberg, EPB Macro Research

The current slowdown in employment growth, specifically cyclical employment growth, is severe and can be seen in many economic data points. If leading indicators of economic growth were turning higher, however, and cyclical employment growth started to increase, the economy may very well avoid a recession.

The negative shock of the Coronavirus has likely caused employment plans to freeze, irrespective of any increase in borrowing costs.

If the Coronavirus continues to cause a sell-off in risk assets and spreads start to widen faster than Treasury rates decline, corporations will be faced with higher borrowing costs at a time when economic growth was on shaky ground to being with.

Employment Growth Trend Relative To Past Samples:

Source: Bloomberg, EPB Macro Research

Should an increase in borrowing costs accelerate the decline in employment growth, and the black line in the chart above drifts into the yellow circle, a recession will be tough to avoid.

Clearly, a call for a recession is premature, and my economic outlook has zero forecasts concerning the virus or any predictions regarding a conclusion.

Rather, when constructing an allocation to weather a shock, we must be mindful of the current state of the economy and the susceptibility to a recession from a negative event.

Currently, a recession is not imminent based on the data above. Still, the situation can evolve quickly, and the economy is far from immune to a shock in its current state.

Keys To Watch and Outlook

The increase in corporate bond yields late in 2018 was small in relation to other recessionary periods. Still, given

  • the level of corporate leverage,
  • anemic profit growth, and
  • weak economic conditions,

a smaller increase can have a more significant impact.

Employment growth has been in a downtrend since that late 2018 period, contributing to weaker rates of consumption growth seen in recent reports.

The economy is not imminently vulnerable to a recession, but that can change in a matter of weeks. The impact on employment is the key to watch when judging lasting recession risk.

Moving forward, if the current shock causes employment growth to suffer, already in a fragile state, recessionary conditions will be tough to avoid.

An acceleration in corporate layoffs will be exacerbated by higher borrowing costs, making credit spreads and bond prices a vital signal.

Given the susceptibility to a recession pending a worsening of conditions, investors should consider an added layer of protection should this negative shock take a turn for the worse.

If conditions worsen or simply do not improve for several weeks, a recession may be difficult to avoid, mainly due to the initial conditions before the shock began.

If the economy does tumble into a recession, risk assets are highly exposed, and a continued overweight allocation to Treasury bonds and gold will likely offer the best protection.

The model portfolio at EPB Macro Research continues to have an overweight exposure to Treasury bonds and gold.

Impeach Trump. Then Move On.

Stop distracting from the core issue, elite negligence and national decline.

Is it possible that more than 20 Republican senators will vote to convict Donald Trump of articles of impeachment? When you hang around Washington you get the sense that it could happen.

The evidence against Trump is overwhelming. This Ukraine quid pro quo wasn’t just a single reckless phone call. It was a multiprong several-month campaign to use the levers of American power to destroy a political rival.

Republican legislators are being bludgeoned with this truth in testimony after testimony. They know in their hearts that Trump is guilty of impeachable offenses. It’s evident in the way they stare glumly at their desks during hearings; the way they flee reporters seeking comment; the way they slag the White House off the record. It’ll be hard for them to vote to acquit if they can’t even come up with a non-ludicrous rationale.

And yet when you get outside Washington it’s hard to imagine more than one or two G.O.P. senators voting to convict.

In the first place, Democrats have not won widespread public support. Nancy Pelosi always said impeachment works only if there’s a bipartisan groundswell, and so far there is not. Trump’s job approval numbers have been largely unaffected by the impeachment inquiry. Support for impeachment breaks down on conventional pro-Trump/anti-Trump lines. Roughly 90 percent of Republican voters oppose it. Republican senators will never vote to convict in the face of that.

Second, Democrats have not won over the most important voters — moderates in swing states.New York Times/Siena College survey of voters in Arizona, Florida, Michigan, North Carolina, Pennsylvania and Wisconsin found that just 43 percent want to impeach and remove Trump from office, while 53 percent do not. Pushing impeachment makes Democrats vulnerable in precisely the states they cannot afford to lose in 2020.

Third, there is little prospect these numbers will turn around, even after a series of high-profile hearings.

I’ve been traveling pretty constantly since this impeachment thing got going. I’ve been to a bunch of blue states and a bunch of red states (including Kansas, Missouri, North Carolina, Tennessee, Texas and Utah). In coastal blue states, impeachment comes up in conversation all the time. In red states, it never comes up; ask people in red states if they’ve been talking about it with their friends, they shrug and reply no, not really.

Prof. Paul Sracic of Youngstown State University in Ohio told Ken Stern from Vanity Fair that when he asked his class of 80 students if they’d heard any conversation about impeachment, only two said they had. When he asked if impeachment interested them, all 80 said it did not.

That’s exactly what I’ve found, too. For most, impeachment is not a priority. It’s a dull background noise — people in Washington and the national media doing the nonsense they always do. A pollster can ask Americans if they support impeachment, and some yes or no answer will be given, but the fundamental reality is that many Americans are indifferent.

Fourth, it’s a lot harder to do impeachment in an age of cynicism, exhaustion and distrust. During Watergate, voters trusted federal institutions and granted the impeachment process a measure of legitimacy. Today’s voters do not share that trust and will not regard an intra-Washington process as legitimate.

Many Americans don’t care about impeachment because they take it as a given that this is the kind of corruption that politicians of all stripes have been doing all along. Many don’t care because it looks like the same partisan warfare that’s been going on forever, just with a different name.

Fifth, it’s harder to do impeachment when politics is seen as an existential war for the future of the country. Many Republicans know Trump is guilty, but they can’t afford to hand power to Nancy Pelosi, Elizabeth Warren or Bernie Sanders.

Progressives, let me ask you a question: If Trump-style Republicans were trying to impeach a President Biden, Warren or Sanders, and there was evidence of guilt, would you vote to convict? Answer honestly.

I get that Democrats feel they have to proceed with impeachment to protect the Constitution and the rule of law. But there is little chance they will come close to ousting the president. So I hope they set a Thanksgiving deadline. Play the impeachment card through November, have the House vote and then move on to other things. The Senate can quickly dispose of the matter and Democratic candidates can make their best pitches for denying Trump re-election.

Elizabeth Bruenig of The Washington Post put her finger on something important in a recent essay on Trump’s evangelical voters: the assumption of decline. Many Trump voters take it as a matter of course that for the rest of their lives things are going to get worse for them — economically, spiritually, politically and culturally. They are not the only voters who think this way. Many young voters in their OK Boomer T-shirts feel exactly the same, except about climate change, employment prospects and debt.

This sense of elite negligence in the face of national decline is the core issue right now. Impeachment is a distraction from that. As quickly as possible, it’s time to move on.

The Dangers of Hiring for Cultural Fit

Employers often aim to hire people they think will be a good fit, but their efforts can easily veer into a ditch where new hires all look, think and act alike

What happens when a boss tries to foster a more inviting workplace, but not everyone feels invited?

Employers often aim to hire people they think will be a good “cultural fit,” with attributes that will mesh with a company’s goals and values. But their efforts can easily veer into a ditch where new hires all look, think and act alike. That’s bad for anyone who cares about an office with a mix of races, genders and points of view.

“What most people mean by culture fit is hiring people they’d like to have a beer with,” says Patty McCord, a human-resources consultant and former chief talent officer at Netflix. “You end up with this big, homogenous culture where everybody looks alike, everybody thinks alike, and everybody likes drinking beer at 3 o’clock in the afternoon with the bros,” she says.

Human-resources consultant Patty McCord says some employers err in trying to attract top talent by offering such frills as office ping pong or the latest craft beer. PHOTO: DEVI PRIDE

An alluring culture is a coveted prize in today’s tight labor market, surging to first from fifth place in the last five years as the most important factor in recruiting top talent, according to a 2018 Korn Ferry survey of 1,100 hiring managers. But there’s a difference between cultural frills like office ping pong and craft beer, and deeper ones that mean more. To employees, it means loving a job for more than just the paycheck. And to employers, it means employees will keep working hard even when no one is watching.

Making a good match can be difficult. In a pattern researchers call looking-glass merit, hirers tend to look for traits in candidates that make them feel good about themselves. These may be more nuanced than race or gender. A manager who got bad grades as a college freshman is likely to warm to an applicant who also got off to a rough start, research shows. Or a hirer who attended a low-prestige school may favor applicants who did the same.

“What most interviewers are looking for and acting on is more of an intuitive sense of, ‘Would I get along with this person?’ and that often isn’t very reliable,” says Kirsta Anderson, global head of culture transformation in London for Korn Ferry.

Employees err in taking a job because it offers office ping pong, free lunches or heated toilet seats. Ms. McCord recently met an HR executive who claimed to keep employees happy by serving up the latest craft beers. “Well, that sounds like a fun vacation. I’d probably go to that resort. But that’s not what you’re here to do,” says Ms. McCord, author of “Powerful,” a book on building workplace cultures.

Hiring managers need to go deeper and figure out whether applicants are in sync with more fundamental elements of their culture, Ms. Anderson says. Are they excited about how the company innovates, serves customers or makes a social impact? Will they mesh with the way individuals and teams at the company work, by collaborating or competing? And will they naturally make decisions the way the employer wants—individually or as a group, embracing or avoiding risk?

It isn’t easy to suss out those traits in an interview. Jeanne Leasure, a human-resources executive, recalls interviewing applicants for a job that gave employees a lot of autonomy. She was looking for recruits who were self-starters, but wound up hiring one who turned out to be a lovable slacker. “We hit it off, we had similar personalities,” and the applicant gave convincing answers when she asked him about past accomplishments, she says. But on the job, he didn’t have as much drive as she’d hoped, says Ms. Leasure, who was recently named senior vice president, people, at SpotX, an ad-tech company based in Broomfield, Colo. She has begun asking more probing questions, such as, “What was your work ethic like as a teenager?”

Ad-agency founder Ed Mitzen looks for recruits who are empathetic and at ease in his company’s flat, no-titles, team-based culture. PHOTO:FINGERPAINT

Fingerpaint Marketing is a flat organization with no lofty job titles, and its teams must work smoothly together on tight deadlines. When Ed Mitzen, founder of the Saratoga Springs, N.Y., agency, interviews candidates, he explores whether they’ll be kind to everyone regardless of status, and pleasant to work with. If teammates enjoy working with them, he reasons the team will get more done and do better work.

He screens out big egos partly by asking drivers for his company’s car service how candidates treated them en route to and from the interview. “If they’re a jerk to the car-service guy, that’s a warning sign,” Mr. Mitzen says. He once rejected an applicant partly because he put on airs with the driver and expected him to open the door for him.

“Really? You’re applying for a $150,000-a-year job,” Mr. Mitzen says. “You’re not applying to be ambassador to France. Take it easy.”

The best hires find the company’s business goals motivational, Ms. McCord says. “A big filter for hiring people at Netflix was, were they interested in our goal of making the customer happy?” Ms. McCord says. She invited applicants to see the customer as someone like their mom—not the engineer at the next desk, she says.

Many employers post their cultural values on the wall but fail to make them explicit to job applicants, says S. Chris Edmonds, author of “The Culture Engine.” This can easily lead to misfires. Some 7% of workers ages 24 to 36 say they dislike their employer’s culture so much that they intend to quit their jobs in the next two years, according to a 2019 survey by Deloitte of 13,416 millennial employees.

More young workers are holding employers accountable for their values, and insisting that their companies stand for something, Mr. Edmonds says. Some 32% of millennials say businesses should try to reduce inequality and support better education, but only 16% of the employees say companies are actually doing so, the Deloitte survey shows. And while 27% of millennials think businesses should protect the environment, only 12% believe they’re doing so.

The growing employee activism is marked by walkouts protesting employers’ stance on the environment, immigration policy or use of their technology for military drone strikes. Some 38% of developers have approached their leadership with such misgivings or concerns, according to a recent HackerRank survey of 71,000 software developers.

All that promises to put more CEOs on the hot seat. As employees become more vocal, “C-suite leaders will have to listen,” Mr. Edmonds says. And that, he says, is a good thing: “It helps employers get clearer about, ‘This is what we stand for.’ ”

If a Law Bars Asking Your Past Salary, Does It Help or Hurt?

“It seems like the general social impulse is, ‘We don’t like employers using particular information, so we’ll tell them they can’t use it any more and assume that’s the end of the conversation,’” said Jennifer Doleac, an economist at the University of Virginia. “But if they cared enough about it to ask it to begin with, they probably care about it enough to try to guess.”

.. (Alternatively, employers may try to get the information in slightly less direct ways, like asking candidates about their minimum salary expectation, Mr. Klein said.)

.. They typically allow job applicants to disclose their previous salary voluntarily. As a result, some employers may feel comfortable making lowball offers to women, because they assume applicants will speak up if they make significantly more than the employer’s offer. Those who don’t speak up will be deemed to have made less.

This could, in turn, leave women worse off than before, since they tend to be more reluctant to bargain than men, as a range of studies have documented.

.. By asking what the candidate currently makes and paying the same or slightly more, an employer may simply want to ensure that an offer is accepted and that the new hire is satisfied — but may be oblivious to the risk of perpetuating pay disparities.