Reverting to one of his favorite topics - namely how the application of a statistical average of a sharply bimodal sample tends to muddle the resulting signal, something Ray Dalio expounded on as recently as last month- on Monday morning, SocGen's Andrew Lapthorne explains not only why the true story of US corporate balance sheets is far worse than the average data makes it appears, but also why "US balance sheet performance is increasingly polarized".
As the SocGen strategist writes, "we have been highlighting for some time now the risks associated with highly leveraged US companies, particularly among the smaller capitalisation names. Our message has been clear; US corporate leverage is abnormally high for this stage in the cycle and a handful of cash-rich mega caps are masking significant problems elsewhere."
To be sure, the market has noticed this growing balance sheet chasm, and as a result aversion to highly leveraged companies has become increasingly visible:
"over the last few weeks the beta of bad balance to good balance sheet companies has been negative. Or to put it more simply, one group has been going up whilst the other has been going down. For those still holding the weak companies, the relative performance consequence is painful, leading to further selling and further polarisation."
To be fair, Lapthorne picks up on a point that was brought up by the IMF back in April, when it not only warned that over 20% of US corporations are at risk of default should rates rise even modestly, but that the generous use of an average distribution when instead median is more appropriate, is masking some substantial problems below the surface, including the risks to US corporate from rising interest costs and possibly a reduction in
interest cost tax deductibility.
Putting this in perspective, Lapthorne calculates that while on average interest cost as a % of EBIT remains very healthy (as you would expect with record low interest rates) "once you peel away the biggest and strongest US companies, the picture is entirely different." As shown in the chart below, and as Lapthorne notes, "interest coverage for the smallest 50% of US companies is near record lows, at a time when interest costs are extremely depressed and when profits are at peak."
As Lapthorne concludes, "It is difficult to envisage a scenario in which this ends well."