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Monday July 23, 2007 - 11:47:18 GMT
Lloyds TSB Financial Markets - www.lloydstsb.com/corporatemarkets

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Economics Weekly: UK corporate sector is profitable but debt levels are rising; Weekly economic data preview: US Q2 gdp and housing market data the key releases this week

Economics Weekly

 

UK corporate sector is profitable but debt levels are rising

 

Just how strong is the UK company sector?

Defaults are at a 15 year low, cash flow is firm and overall company profitability is still at its strongest levels since data were collated on this basis in 1993. This would seem to suggest that there is nothing to worry about and that this fully justifies the rise in equity market valuations and continued narrow spreads on all classes of company bonds to government bonds. Moreover, in a period of rapid global and sustained UK economic growth for the past 15 years, the risk of corporate defaults becoming a major problem also seems limited. But is this healthy picture the whole truth? Getting this right is vitally important, as corporate gearing has implications for monetary policy and for financial markets. A rise in defaults could hit the financial sector, if it increases losses and so makes them reluctant to lend, so slowing economic growth as well. But it would also lead companies to cut back on investment spending, so weakening activity. In turn, slower economic growth would make it easier for the inflation target to be met and so also has implications for monetary policy.

 

Looking at the corporate balance sheet

Our analysis of UK corporate gearing (interest paid versus annual operating profit) suggests that the situation is not as sanguine as the headline numbers would suggest and that the effect of higher interest rates and slower economic growth in the years ahead may lead to a higher level of defaults than currently expected by the monetary authorities and by financial markets. If so, this is currently perhaps not adequately priced into bond spreads. This would suggest that the negative effect on economic growth from slower growth in business investment spending is also being underestimated, along with the concomitant higher level of defaults.

 

Income gearing of UK companies is up

In terms of interest paid, UK corporate income gearing fell sharply from 1990 to 1996, since when it began to rise to a peak in 2000/01 before falling again, see chart a. Sharply lower interest rates between 2001 and 2003 meant that corporate income gearing stayed low in that period. But as interest rates began to rise in 2005, income gearing started to rise as well. It is currently well below the peak in 1990, but slower growth and high interest rates into 2008 suggest that this rise will continue into next year. Currently, interest paid as a share of income by companies is well above the average of the last 20 years. Interest rates in the next few years are estimated to be some 1% above the level of the preceding five years, so income gearing is not expected to fall much below the 20 year average, even though we look for official interest rates to be cut in 2008. Moreover, as chart b shows, we also expect the rise in gearing and slower economic growth to combine and result in higher bankruptcies. When this becomes the reality facing bond investors, only then perhaps will we find out whether the outcome had been adequately priced into bond spreads. The good news is that the rise in insolvencies that we are projecting is still well below the experience of the early 1990s and so should not lead to too much of a shock to corporate spreads.

 

Corporate capital gearing is up

There are a variety of ways of measuring capital gearing - but we have used all corporate loans plus securities as a ratio of total financial assets. Other methods show the same trend, though the levels may be different. In chart c, corporate debt, as defined, against corporate income shows that gearing has risen enormously since the low in 1996 and now stands at nearly 5 times annual income, roughly in line with leverage in many hedge fund and private equity type markets. But we need to take account of company asset growth, so chart d is the measure of capital gearing we should focus on. It shows a similar pattern to income gearing, but the rise since the low in 2000 has been uninterrupted by the interest rate cycle. Indeed, the upward slope of the curve since 2003 has been even more pronounced. Company gearing is now above the 20 year average, after being below briefly in 2000/01, and is above its high in 1990, a period that was followed by a deep recession. This is not to say that corporate gearing caused this, clearly not, but the fall out from it for the corporate sector was much more damaging because higher levels of debt meant that when the crisis hit, assets were not enough to prevent wide spread bankruptcies. The reason of course is that asset values fall in recessions and investors usually become more risk averse and reluctant to invest.

 

What appears to be fuelling the current upswing in debt and what are the consequences?

Record acquisition and mergers activity globally and in the UK would seem to be the obvious

answer, as well as strong growth in investment spending. This high level of debt may also explain why companies are now also sitting on an excess of around £100bn of cash. A look at chart e, the composition of company debt, between loans, securities and equities shows the source of the biggest changes over the period we analyse. Issuance of securities (fixed income paper or bonds) has risen as a share of total debt. This might be taken by some as a sign that more takeovers are now being characterised by greater issuance of bonds than in the past. This may be right, and fits in with the abundant liquidity that is available, stemming from strong global growth, the innovation of financial instruments and in the growth of new finance companies other than banks. The conclusion, however, is that the UK corporate sector is perhaps more vulnerable to an economic downturn than is observed from just looking at profits and the strong economic growth rate of the last few years.

 

Trevor Williams, Chief Economist

 

Weekly economic data preview

 

US Q2 gdp and housing market data the key releases this week

 

• Annualised US real gdp growth is forecast to have rebounded strongly in Q2, to 3.5%, compared to just 0.7% in Q1. We expect a solid positive contribution from external trade, stronger business investment and a re-stocking of inventories in Q2. However, continuing concerns about the health of the housing market and higher gasoline prices may have slowed consumer spending growth from its robust 4.2% pace in Q1, and residential investment is likely to have again detracted sharply from overall gdp growth.

 

• We agree with the comments from Fed chairman Bernanke last week in his testimony to the House Financial Services Committee that the housing market is set to remain weak and a drag on the economy for longer, rather than collapse. Data this week should show sales of existing and new homes remained weak in June, leading to a growing over-hang of unsold homes, which is likely to continue to weigh on construction activity and house prices. However, we believe a healthy labour market and lower house prices should eventually support stronger home sales in the year ahead.

 

• The recently introduced 'flash' euro zone manufacturing and services PMIs, on Tuesday, should show growth prospects remain solid. However, following a surprisingly weak German ZEW survey last week, the more influential German IFO survey, on Thursday, could show a second consecutive monthly fall. We look for a modest rise based on robust factory orders and industrial activity. The strong M3 money supply data for June will also continue to signal the strong prospect of 4.25% interest rates by September/October.

 

• It is a quiet week for UK data. The Nationwide house price survey is forecast to show prices rose for the 15th successive month in July, but at a sharply slower pace than in June and the annual rate is set to slow to 10.6%. Mortgage approvals are slowing, they peaked in the final quarter of 2006, but suggest slower house price growth and no collapse. The CBI industrial trends survey is forecast to show a fall in its headline orders index to +5, from +8 in June, reflecting the stronger exchange rate and also moderating domestic demand in the face of higher interest rates.

 

Comments from Fed chairman Ben Bernanke last week at his semi-annual testimony to the House Financial Services Committee suggested the prospects of a cut in US interest rates this year are slim, despite the current woes in the subprime mortgage market and moderation seen in monthly core inflation. The Fed believes, as we do, that US economic growth will pick up towards its trend rate of around 2.75% in the quarters ahead, supported by a healthy labour market and also a reduced drag from the weak housing market. The risk is that with core inflation currently close to the top end of the Fed's stated 1-2% comfort level, at 1.9% in May, if growth picks up it would see upside pressure on inflation develop quickly in 2008, as spare capacity is limited. Rising energy and commodity prices also represent another inflation risk, especially since crude oil is already close to its record highs. The Q2 gdp data this week will therefore be informative about growth trends in the economy and a strong rebound is widely expected after growth dropped to its slowest pace in four years in Q1. The chart shows the softness in Q1 growth reflected generalised weakness in all of the main gdp components, with the crucial exception of personal consumption, something that should be reversed in Q2. Data show inventories are being replenished rapidly and a stronger profile for durable goods orders suggests business investment picked up in Q2. Exports hit a record $132bn in May, reflecting the weaker dollar and strong global demand. We look for gdp growth of 3.5% in Q2, but it could be higher if consumer spending also stayed more buoyant.

 

Housing market data this week are forecast to show a further fall in the annual rate of sales of existing and new homes in June, reflecting continuing housing market concerns, higher mortgage rates and tighter lending conditions.

 

In the euro zone, data this week are expected to underline the ECB case for higher interest rates. The July PMI data will show activity remained buoyant in services and manufacturing, if slightly slower than June. The German IFO is forecast to rise modestly in July, but even a small decline should not raise much concern, given it will still remain close to decade highs. Equally, EU-13 money supply growth is likely to have remained in double-digits and also close to decade highs in June though it may slow. We forecast the ECB will raise interest rates in September or October.

 

As highlighted above, it is a quiet week for UK economic data. They are unlikely to have much impact on market interest rate expectations or foreign exchange markets. We remain of the view that UK interest rates will peak at 5.75% and look for sterling to weaken during the year.

 

Jeavon Lolay, Senior Economist

 

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