Economic Brief: High Yields and Hard Lessons

Against the backdrop of rising interest rates, this quarter’s economic perspective from Jon Manchester, CFA, CFP® (Senior Vice President, Chief Strategist – Wealth Management, and Portfolio Manager – Sustainable, Responsible and Impact Investing) delves into the intricate balance between financial stability and market volatility.

It looked good on paper. Almost any investment yield does, when interest rates are close to zero. The math gets progressively less favorable when borrowing costs normalize. Just ask investors in Atlanta-based Newell Brands, which stables Rubbermaid, Sharpie, Graco, Coleman, and other well-known brands. As 2023 began, the stock offered an enticing 7% dividend yield. For those unable to resist the siren call, the yield turned out too good to be true. By the end of April, Newell’s stock price was down 7% year-to-date, effectively wiping out the indicated annual yield. Then in mid-May, Newell issued a press release announcing the quarterly dividend would be slashed to $0.07 per share from $0.23 previously. According to the company, the dividend “right-sizing” would allow Newell to de-leverage the balance sheet faster, plus fund supply chain consolidation efforts and provide greater financial flexibility overall. The roughly 70% dividend cut sent the stock price tumbling further, and by the end of the third quarter shareholders were left lamenting a -29% total return for 2023 thus far.

As a young man from Northern Minnesota named Bob Dylan once sang, the times they are a-changin’. In July, the Federal Reserve (the “Fed’) hiked the Fed Funds target range to 5.25% to 5.50%, the eleventh tightening in a 17-month stretch. This has intentionally poured cold water on capital markets activity, and therein lies a problem for companies such as Newell Brands who have been more heavily reliant on external financing.

In 2016, Newell splashed out $15 billion to merge with Jarden Corporation, a deal that more than quadrupled Newell’s long-term debt load to over $12 billion. It eventually resulted in a junk credit rating at Standard & Poor’s for Newell, which meant higher borrowing costs. Following a challenging 2022 from a cash flow standpoint, and with a hawkish Fed taking rates higher, Newell had to face reality and prioritize paying down debt. In attempting to both grow the business and keep income-focused shareholders satisfied, Newell realized it could no longer serve both masters.

This cautionary tale is another reminder that chasing high yield stocks can be a short-sighted strategy, particularly when a company is overly reliant on cheap financing to make it all work. We should be careful about reading too much into one company’s travails, but it seems likely other highly-indebted companies will encounter similar struggles. With the Zero Interest Rate Policy (ZIRP) days quickly fading from memory, the macroeconomic waters may not be quite as inviting in the near-term. Along those lines, Strategas Research chief economist Don Rissmiller has compared restrictive monetary policy to (collectively) holding our breath under water, and at risk of stating the obvious, he notes the longer we do so the more dangerous.¹ The U.S. economy appears adequately buoyant at present, but it is reasonable to fret that the Fed’s aggressive battle against inflation—which is not yet mission accomplished—may cause more collateral damage.

Until Something Breaks
Longer-dated U.S. Treasury yields have risen in part due to greater acceptance of the “higher for longer” narrative. By that meaning the Federal Reserve may plateau the Fed Funds target rate at a restrictive level for a longer period of time than originally anticipated. First, though, the Fed needs to stop hiking, and in late September its “dot plot” indicated that 12 of 19 officials favored another rate increase this year. The Fed’s median projection for the year-end 2024 Fed Funds target rate was 5.1%, only slightly below the current level, and up from 4.6% previously. It’s worth acknowledging that only recently has the Fed Funds target rate actually exceeded the inflation rate. That crossover occurred in June, using the Consumer Price Index (CPI) excluding Food & Energy. For inflation to be truly quieted, the Fed will likely want to see prices remain below the policy rate for an extended timeframe.

Higher rates typically portend trouble for companies with weaker balance sheets. Firms that aggressively borrowed during the funny money years now encounter a new landscape, whether they need to refinance debt or borrow new funds. Equity markets have already started reflecting this in prices. One way to measure financial leverage is to look at a company’s net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio. On a year-to-date basis through September, the S&P 500 companies in the highest decile on that metric produced a -6.6% median total return.² Dispersion was wide within that decile, with cruise line stocks soaring while Dish Network and other heavily indebted names mightily struggled. The bottom decile—those companies with low debt in relation to earnings—produced a median return of 13.4%. As the tide goes out, it does appear that highly-levered companies are being stranded on the beach.

Goldman Sachs maintains various equity baskets to evaluate how certain factors are performing. Its “Strong Balance Sheet” sector-neutral basket includes 50 stocks from the S&P 500 with high Altman Z-scores, a measure of financial health. As shown in Exhibit 1, this basket of stocks has performed well relative to a basket of “Weak Balance Sheet” stocks over the past decade. Thus far in 2023, the strong balance sheet basket has outpaced the weaker balance sheet stocks by approximately 14 percentage points.³ This factor may be increasingly important as the economic cycle reaches its final stages. According to a Bloomberg article in July, nearly $600 billion of debt globally traded at distressed levels – defined as below $0.80 on the dollar and with a spread greater than 1,000 basis points.^{4, 5} More than a quarter of the distressed debt is tied to the real estate sector, more than any other industry group. To this point we haven’t seen any widespread outbreak of corporate defaults, although the collapse of Silicon Valley Bank and two other banks in March did briefly rattle investor confidence.

With the Fed’s proverbial foot firmly on the brake, it seems wise to pay close attention to the credit markets for signs of trouble.

Balancing Act
Appearances can be deceiving. There is a strong argument that the 13% total return for the market cap-weighted S&P 500 Index through the first three quarters of 2023 falls under this rubric. In comparison, the S&P 500 Equal Weighted Index managed less than a 2% return, lacking the cap-weighted upside provided by heavyweights Nvidia, Apple, Microsoft, and others. The latter feels more consistent with the big picture, including fairly sluggish earnings growth. Trailing twelve-month operating profits for the S&P 500 of roughly $208 per share through the second quarter were up less than 2% year-over-year. Wall Street expects that growth rate to improve over the final two quarters, but there are questions around the durability of profit growth in the face of higher input and borrowing costs.

U.S. Treasury Secretary Janet Yellen is not worried. When asked in September about the hopes for a “soft landing” in which a recession is avoided and inflation tamed, Yellen responded “I think you’d have to say we’re on a path that looks exactly like that.”⁶ The improvement in inflation is well documented: from a peak 9.1% rate for CPI ex-Food & Energy in June 2022 to 3.7% in the most recent (August 2023) reading. Yellen also highlighted an increase in labor force participation as “a clear plus” amid some easing in the labor markets. Although not a leading indicator, the U.S. employment picture remains encouraging. Nonfarm payrolls jumped 336,000 in September, while the unemployment rate stayed at 3.8%. This is particularly important because for consumers the excess savings are gone, according to the Federal Reserve’s latest survey of household finances. For the bottom 80% of households by income, aggregate bank deposits and other liquid assets were lower in June 2023 than they were in March 2020, inflation-adjusted.⁷ For those in the wealthiest quintile, the remaining excess savings were expected to have depleted in the third quarter. Sobering, perhaps, although the same Fed report indicated that household net worth rose approximately $5.5 trillion during Q2 to a record-high.

Economists seem to have largely thrown in the towel on their recession calls. That could be a contrarian indicator, but to be fair, economic forecasting is exceedingly complex. There are political footballs being thrown around the Beltway that may cause a government shutdown, with higher U.S. Treasury interest rates causing budgetary stresses here as well. China is planning to take back their Giant Pandas from U.S. zoos, seemingly a new low in our diplomatic ties. War has once again broken out in the Middle East, and trudges on in Ukraine. It’s a mad world, full of unknowns, and boiling down all these variables might lead us back to restrictive monetary policy and its intended effects. The economic gears should turn more slowly in this higher rate environment, resulting in a more cautious capital allocation approach by corporations.

1 “Weekly Economics Summary,” Strategas Research, 10/1/2023.
2 Bloomberg data, Bailard calculations, 9/30/2023.
3 Strong Balance Sheet US / Weak Balance Sheet US, Goldman Sachs Marquee platform, 9/29/2023.
4 A basis point (“bp”) is 0.01%.
5 “A $500 Billion Corporate-Debt Storm Builds Over Global Economy,” www.bloomberg.com, 7/18/2023.
6 “Yellen ‘Feeling Very Good’ About US Sticking a Soft Landing,” www.bloomberg.com, 9/10/2023.
7 “Only Richest 20% of Americans Still Have Excess Pandemic Savings,” www.bloomberg.com, 9/25/2023.