Second quarter observations
Over the last three years, U.S. large cap companies have been boosting profitability through increased leverage.
Since the financial crisis, we’ve seen two distinct periods of stock buy-backs, first driven by cash flows and second driven by borrowing. U.S. large cap companies bought back shares at a record pace, which resulted in fewer shares outstanding. Much of this initial share repurchasing activity was financed without any incremental debt. However, since early 2015, the continued reduction in shares outstanding has coincided with a significant increase in total debt (chart 2), suggesting companies have been financing share repurchases with additional leverage. As a result, companies look more profitable on ROE due to less outstanding equity, but they are also more highly leveraged due to the debt financing.
Coming out of a historically low interest rate environment, more profitable companies today may face challenges in the future as the costs of debt servicing could increase with higher interest rates. Profitability is widely considered a measure of high quality companies, but today it may be a riskier metric than usual. Investors should pay attention to the changing profile of profitability, particularly in event of market corrections.
Second quarter overview
Although ongoing trade-war rhetoric and rising oil prices continued to worry investors, U.S. equities overcame these headwinds as corporate earnings continued to come in strong during the second quarter and the S&P 500® Index gained 3.4%.
As crude oil prices exceeded $70 a barrel for the first time in nearly three years, companies in the energy sector were some of the best performers during the quarter. Consistent with a recovery in commodity prices, companies with positive exposure to inflation also outperformed.
As concerns mounted over the impact of trade wars, companies with positive exposure to interest rates (i.e. financials) underperformed, and smaller companies outperformed larger multi-nationals due to their greater domestic orientation. Additionally, elevated trade tensions led to a pullback in technology and a recovery in out-of-favor defensive sectors, which caused a correction in both growth and momentum.
Underperformance of value
Despite a late quarter reversal in growth and momentum, value continued to lag as more expensive companies in energy and consumer discretionary led market returns. Over the trailing 12 months, value factors have been some of the worst performers.
The S&P 500 Index is a capitalization-weighted index of 500 large-cap U.S. stocks. Investments cannot be made in an index.