Economy

Corporate Debt and the Great Margin Call of 2020

us corporate debt

We’re 75 days into 2020, and it’s already been one hellish year.

The most powerful people in the world, from presidents to central bankers, are all trying to stop one thing right now: a global credit crisis. At the heart of their fears is record US corporate debt that stands at over $10 trillion.

Despite the Federal Reserve Bank of New York announcing up to a potential $1.5 trillion in financial stimulus on Thursday (more than double the United States’ military budget for FY2019), investors are split on whether or not it will be enough. Make no mistake, this program – which is intended to provide unprecedented short-term liquidity – will have long-term implications.

If the coronavirus pandemic shows signs of peaking in the next 2-3 weeks, the bull market will likely resume and credit markets will be saved. If it is a longer, drawn out process, the entire global financial system is at risk – akin to what we saw in 2008. Thursday’s and Friday’s market activity is evidence enough to support this statement.

The coronavirus combined with the collapse in the price of oil created a true Black Swan moment; something the Fed and everyone else on planet Earth could not have seen coming. Regardless, this double whammy puts the credit markets in jeopardy, as bankruptcies loom in the oil patch. This could easily spill over into numerous sectors, given how leveraged many key American corporations are.

US corporate debt is the most dangerous threat the Fed is concerned about. It could be the catalyst for yet another global financial meltdown.

The Fed knows that if the corporate debt bubble – which has been building for the past 11 years – bursts, it will wreak havoc on the global economy.

Debt-Based Monetary System on Life Support

A debt-based monetary system cannot survive in a deflationary environment. The developed world is simply carrying too much debt to endure any kind of long term or significant contraction. Inflation for our modern financial system is akin to oxygen for our bodies – without it, we can’t survive.

On February 16th, we wrote in a Weekly Intelligence Newsletter titled, Longest Bull Market in U.S. History Immune to Coronavirus?, that a recession in China would likely result in a market crash in the United States:

“A recession in China would likely end the longest bull market in U.S. history…”

Since then, the S&P 500 and all US indices have cratered, entering bear market territory on Wednesday.

1 Month Chart of S&P 500
1 month chart for the S&P 500

 

The World Enters Recession

On March 4th, CNN Business published China’s economy could shrink for the first time in decades because of the coronavirus, in which they reported,

“Chinese media group Caixin said its purchasing managers index for the sector plummeted to 26.5 last month from a reading of 51.8 the month before…”

This is the lowest reading for China’s PMI to date. In other words, China’s manufacturing sector is performing worse today than it was during the depths of the Great Recession.

The aforementioned article goes on to state,

“China’s factories also recorded their worst month on record in February, according to government and Caixin data, as companies face extended closures to contain the virus, or struggled to fill jobs because of travel restrictions.”

Europe, which was already nearing recession before the coronavirus outbreak, is now facing extreme economic pressure due to quarantines and social distancing measures across the continent. Because of this, JPMorgan is forecasting a recession in European economies by July.

Look at Canada. In Q4 2019 (before coronavirus was much of a talking point), its economy grew at 0.3%. Where do you think it is today? Especially considering oil’s 30% price plunge. It’s little wonder why the Bank of Canada one upped the Fed and dropped its key lending rate by 0.75% on Friday. That is a desperate move.

Central Bankers Are Worried

Central bankers are worried about corporate bonds defaulting, and here’s why: since the financial crisis of 2008 and the era of ZIRP (zero interest rate policy), corporations have piled on more debt than households and even some nations. The money was practically free (thanks to historically low interest rates), and because of this, they’ve been taking it for the past 11 years or so.

As valuations and earnings drop, highly leveraged companies with low-rated corporate debt will come under serious pressure. And if the spread of coronavirus does not subside within the next 2-3 weeks, expect defaults and potentially many bankruptcies.

US Corporate Debt Bubble

Chart of nonfinancial corporate business debt from Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis

 

Notice the dramatic increase in corporate debt after the 2008-2009 recession.

To say we are in uncharted waters is a grand understatement. Just as governments bailed out the banks and other ‘too big to fail’ entities, they may soon have to bail out debt-laden corporations like never before.

Corporate Debt Bomb About to Blow?

An article by the New York Times titled, Coronavirus May Light Fuse on ‘Unexploded Bomb’ of Corporate Debt, explains the increase in corporate debt in simpler terms,

“Since 2008, corporations worldwide have issued about $1.8 trillion in new bonds each year, a pace roughly double the previous seven years, according to the O.E.C.D.”

Commercial Loans Top All Assets held by Banks

Gretchen Morgenson of NBC News goes on to summarize the phenomenon that rock-bottom interest rates have given birth to,

“For the first time in modern history, commercial loans are the largest group of assets held by banks, surpassing mortgage loans, which had been the top holding.”

And that,

“United States nonfinancial corporate debt outstanding stood at $10.1 trillion in the third quarter of 2019, up from $7.1 trillion in 2013, according to the Federal Reserve Board.”

Finally, Gretchen cites a quote from David Rosenberg, chief economist at investment consulting firm Rosenberg Research,

“Not only has there been a surge in corporate debt, but the quality of the debt is the weakest it’s ever been.”

So, who owns all that debt? Interestingly, banks aren’t even the largest holders. Foreign investors and pension funds are.

Chart of corporate debt holders in the US from Oxford EconomicsIn late October 2019, MarketWatch’s Joy Wiltermuth rang the alarm,

“Credit-rating firm S&P Global earlier this month said that its list of ‘weakest link’ companies reached a 10-year high in September, while Moody’s warned that defaults in junk-bonds could “easily exceed the last cycle.”

And that,

“Some of the most aggressive corporate financing deals of the past decade occurred in the roughly $1.2 trillion leveraged loan market, where last week Bank of America Merrill Lynch analysts pointed to ‘numerous and multiplying’ signs of stress.”

Articles with horrifying, exaggerated titles seem to proliferate once a crisis begins; however, the bond bubble – focused primarily on corporate debt – is real, and the Fed and other central banks are going to have to deal with it.

Corporate Debt in America Stands to Potentially Crash the Economy

In a recession, companies may be unable to make payments based on earnings alone. This results in layoffs and other cuts, which intensify the recession and put further strain on the economy. Massive hoards of cheap debt have found their way on to the books of weak companies, which are more vulnerable to a recession or disruption.

Joe Rennison from the Financial Times’ London office wrote on January 8, 2020,

“While sales of both the safest, triple-A rated bonds and the riskiest ‘high-yield’ bonds have been declining over the past five years, there has been a dramatic rise in the amount of triple-B rated bonds that sit on the lowest rung of the investment-grade ladder, just above high-yield.”

In fact,

“Just two companies in the US — Johnson & Johnson and Microsoft — still have a pristine, triple-A rating, the researchers noted.”

Threat of Corporate Debt Bubble Looms

In 2008, it was the subprime mortgage collapse that led to a global financial crisis. In 2020, it is the current threat of a corporate debt bubble that has forced central banks to unleash trillions in stimulus in a bid to once again keep the global economy from falling to pieces.

Although Q1 will be a nightmare from an earnings perspective, much of this is already priced in. The real problem lies in corporate debt defaults, deflation and a global economy that has its supply chain in jeopardy.

The pandemonium created by the coronavirus is becoming a self-fulfilling prophecy. At a minimum, its laid bare the fragility of our social system. And if the pandemic is prolonged enough, it could lead to a credit freeze, bringing our global financial system to its knees…

We hate to leave this letter on such a negative note, but this has now become an issue of time. Time – especially in a crisis where there’s no clear solution in sight – is the greatest enemy of the markets. For the United States and the Fed, putting a lid on the corporate debt bubble and the trillions in debt coming due over the next few years is priority number one.

All the best with your investments,

 

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