Corporations Drunk With Debt Thanks to Easy Money Punch Bowl
They call it the business “cycle” for a reason. Cycles repeat.
As Peter Schiff pointed out in a recent podcast, the financial crisis was triggered by rising interest rates on the debt that had been accumulated in the years prior as a result of the Federal Reserve keeping interest rates at 1% for a year-and-a-half and then slowly raising them back up over the course of another year-and-a-half.
Friday, the Dow Jones fell more than 600 points. It was the third big drop in a week. Most analysts mention nervousness about sharply rising bond yields as one of the reasons for the selloff. And what do rising bond yields reflect? Rising interest rates. So, are we seeing the beginning of the next big downturn in the business cycle?
When the housing bubble burst to precipitate the financial crisis, the central bankers followed the exact same playbook they did after the dot-com crash. They dropped interest rates and held them artificially low. The difference was Bernanke had to go even bigger than Greenspan. Along with zero interest rates, the Fed launched three rounds of quantitative easing. And instead of maintaining an easy money environment for a few years, the Federal Reserve kept things in place for seven years. The Fed didn’t start nudging rates up until December 2015. It managed to reinflate the bubbles, but today we’re starting to see the negative effects. And even though interest rates are still extremely low by historical standards, we’re beginning to see signs of a taper tantrum in the market.
The economy is addicted to easy money. Even hinting at taking it away is causing significant discomfort, and in some circles, outright panic.
S&P Global Ratings warns that the number of defaults by heavily indebted companies could rise significantly as credit conditions tighten.
It’s not shocking that companies have taken advantage of artificially low interest rates to run up a bunch of debt. That’s the whole point of this monetary policy – to “stimulate” economic growth through borrowing. It’s also not shocking that at some point, one has to pay the piper. Bloomberg summarized the S&P report.
Easy liquidity and underwriting together with low interest rates have contributed to a spike in the number of highly leveraged firms, creating a risk masked by relatively low default rates. Removing the ‘easy money punch bowl’ could trigger the next default cycle since high corporate debt levels have increased the sensitivity of borrowers to elevated financing costs, the ratings agency said in a Feb. 5 report.”
Here we have the business cycle in a nutshell. The economy turns sour. The Fed puts out the easy money punch bowl. The economy gets good and drunk on the punch. The Fed takes the bowl away. The partiers throw a fit.
We’ve talked extensively about the pileup of global debt that has occurred over the last decade. According to the S&P report, the number of “highly leveraged” companies is now higher than it was on the eve of the financial crisis.
The agency defines a company as”highly leveraged” when its debt-to-earnings exceed 5x. In 2007, on the eve of the financial crisis, 32% of corporations fell into that category. According to S&P, 37% of companies hit that level in 2017. Between 2011 and 2017, non-financial corporate debt grew 15% to 96% of GDP.
According to the S&P report, the discrepancy between leverage and defaults has grown so wide that even the recent pick-up in corporate earnings and financial metrics — especially thanks to tax reforms in the US — “won’t be enough to offset” the significant credit risks.
So, how does the Fed continue to”normalize” rates with all of this debt? Will it let the bubbles pop?
The Fed basically has two choices. It can put the punch bowl back on the table, or it can take it let the drunk partiers sober up.
Neither plan bodes well.
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Photo by Shawn Rossi via Flickr.