So far, we have identified a close correlation between credit spreads and future economic activity. When the economy is growing, usually each sector benefits from that growth. In the labor sector, economic growth typically leads to falling unemployment and rising wages. Historically, the corporate sector has benefited particularly during economic expansions. Not only did corporate profits grow in those periods, but also they increased faster than national income. This is reflected by a rising share of national income that usually goes to the bottom-line of the corporate sector during economic expansions. In other words, corporate profitability rises. In recessions, conversely, the labor sector as well as the corporate sector suffers. The problems of the corporate sector become evident by a declining ratio of profits to GDP. Hence, corporate profitability and thus the companies’ abilities to generate cash flows to service their liabilities are highly cyclical. The cyclical nature of corporate profits and cash flows explains variations in corporate bond spreads extremely well. In our view the most objective measure for the ability of companies to service their liabilities is free cash flow. As a proxy for the overall free cash flow that is generated in the US corporate sector, the flow of funds statistics provides a measure that is known as internal funds.
