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Corporate Supply & Flows (JULY 24)

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CreditSights: The Week In Credit

As we approach the halfway mark on the 2Q03 earnings season, it is comforting to know that at least so far, there have been no rude shocks on the negative side and that both past results and future projections have in many instances exceeded expectations. Of course, expectations have been appropriately adjusted based on subdued performance statistics over the past few quarters, and in the current environment, it makes a lot more sense for equity analysts and CEO's alike to be conservative in their estimates. Still, there is good news from Corporate America and expectations are being adjusted upwards even as we wait for the remaining companies to report. Thomson Financial raised its 2Q profit growth estimates for S&P500 index companies from 5.2% earlier this month to 6.9% this week, and has forecast a 13% jump for 3Q, followed by a whopping 21% increase in 4Q. Also, about two-thirds of the companies that have reported so far have exceeded forecasts for this past quarter. Much of the improvement in the topline numbers continues to come from cost cutting generated by layoffs, plant closures and slashed capex budgets, and the weakness in the dollar has allowed companies with cross-border operations to record accounting gains on the foreign currency translation side. While cost cutting and foreign currency gains help to beef up net income, any sustained improvement in fundamentals has to come from a growth in revenues.

Our top down corporate profits model estimates aggregate profits for non-financial U.S. companies is based on quarterly macroeconomic indicators. The model has projected a decline in profits (QoQ) over the past four quarters, and is finally indicating a reversal in trend for 2Q03. Aggregate profits are estimated to increase by 6.4% in 2Q (over 1Q levels). The model includes capacity utilization, consumer confidence, commodity prices, aggregate leverage (measured by debt/market capitalization), corporate bond spreads and real financing costs (inflation-adjusted prime rate). The key drivers of the increase in 2Q profits are higher consumer confidence and reduced funding costs, which are reflected both in the contraction of corporate bond spreads and a lower real prime rate. Corporate bond spreads also incorporate the market's expectation of future performance and the sizeable degree of spread tightening over the past quarter reflects the market's view of an improvement in corporate credit fundamentals. For bondholders however, this could well mean that the market has been fully pre-emptive and even as the news on profits starts to be more positive, there is little further upside in spreads. With the price action in the treasury market indicating that the fixed income arena is facing more hostile conditions in 2H03, it could well be time to take scale back on corporate debt holdings.

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