The signs of the new leverage or debt crisis is here, and the window for any preventative action by regulatory and supervisory authorities is now closing fast. This was the message delivered by the IMF’s Christine Lagarde to the G20 summit in Argentina earlier in December – a message that largely fell on deaf ears of the mass media, preoccupied with geopolitical drama played out in Buenos Aires.
At the time of this article going to print, the U.S. economic cycle is in its 113th month of growth, making it the second-longest period without a recession on record. Based on core fundamentals, ranging from the long-run figures for technological and labor productivity growth to wages and consumer price inflation, from the economy’s output gap to private sector investment in physical, technological and human capital, one finds few reasons for such an impressive growth run. Slower-evolving real growth factors, such as demographic trends, international trade flows, and international aggregate demand changes are more consistent with the story of global stagnation than a robust expansion. In reality, of course, since the end of the global financial crisis, the advanced economies have experienced an unprecedented in history period of overlapping monetary and fiscal stimuli, pushing asset markets valuations to their new historical highs, while inducing ever higher leverage risks in the real economy. Funded on debt and financial engineering, this cycle of financialized growth is now coming to an end.
In a note, published in Nov. 2018, Nomura Holdings research team have looked across nineteen financial metrics that, historically, act as the leading indicators of the shifts in business cycles. Majority of the nineteen indictors are now flashing red, signaling the next recession. Factors associated not only with the rising likelihood of a recession, but also with a potential financial crisis, such as equity and credit markets’ indicators, offer an even more worrying insight.
Of particular concern are the metrics relating to corporate debt markets. Overall, based on the data compiled by HSBC, outstanding U.S. corporate debt averaged 46.3 percent of GDP in the 1960s and 1970s, rising to 58.7 percent in the 1990s and 64.5 percent between 2000 and 2008. Since the end of global financial crisis, this rose to 69.3 percent, with the third quarter 2018-figure standing at an all-time high of 74.1 percent.
Virtually all of this new debt, raised since the end of the last recession, has gone to fund shares repurchases, dividends payouts and opportunistic (as opposed to value-focused) M&As.
Per latest available data, via Yardeni Research and FactSet, S&P 500 shares buybacks are running at their highest level in history, with the 12-month combined volume of repurchases hitting $645.8 billion at the end of the second quarter of 2018. Dividend payouts are also at their all-time high of $444.3 billion over the 12 months through the end of the third quarter of 2018. At the peak of the previous growth cycle in 2007, the combined annualized rate of shares repurchases and dividend payouts stood at around $1.5 trillion. In October 2018, the number was over $2.75 trillion.
U.S. companies are not putting money into future growth. In 2Q and 3Q of 2018, S&P 500 operating earnings averaged $1.2 trillion on a trailing four-quarter basis. Buy-backs and dividends swallowed on average $1 trillion of these. From the first quarter of 2009, the last quarter of the global financial crisis, to the second quarter of 2018, larger U.S. companies have spent $4.28 trillion on share buy-backs. Over the same period of time, U.S. GDP grew by $5.3 trillion in nominal terms. Between share repurchases, M&As (at $1.66 trillion in the twelve months through 3Q 2018), and dividend payouts, major U.S. corporations have financialized $2.75 trillion worth of earnings and leverage over the period during which the U.S. economy is estimated to have grown by about $903 billion in nominal terms.
Put into the context of basic corporate finance, the U.S. economy is now carrying a massive degree of total leverage (DOTL), with a DOTL ratio in excess of 304 percent. Growth, since the end of the global crises has been underpinned primarily by government spending and debt.
Deteriorating quality of debt
Not surprisingly, the second major problem with the current growth cycle is the deteriorating quality of corporate debt.
The Nomura research note mentioned earlier, puts the key to the quality problem at the share of BBB-rated debt in the overall Investment Grade Bond Index. According to their research, thanks to the investment markets boundless thirst for yield, this stands at roughly double the historical average share. The same applies to the leveraged loans. According to S&P Global Market Intelligence, the volume of outstanding leveraged loans in the U.S. currently stands in excess of $1.1 trillion, double the 2012 levels. More than a third of the new leveraged loans issuance is going to roll over existent corporate debt, and about one fifth is underwritten to fund private equity funds’ dividends. The balance is used to fund M&As, corporate buy-outs and shares repurchases.
Unlike traditional corporate bonds and loans, leveraged loans feature floating rates, making them sensitive to the risk of interest rates increases. This risk is partially offset by the fact that leveraged loans usually are collateralized, although the quality of the underlying collateral is often dubious, especially at the times of financial market upheavals. Consider loans covenants – the terms and conditions attached by lenders to mitigate the risks associated with borrower default. Prior to the financial crisis, the majority of leveraged loans came with heavy covenants, and in 2007, covenants-constrained lending accounted for 71 percent of all corporate loans issued in the U.S., according to data from the International Monetary Fund.
For new leveraged loans, Moody’s Loan Covenant Quality Index (LCQI, a measure of strength of covenants, with higher index value reflective of lower covenants restrictions on borrowers), stood at around 2.6. In the first nine months of 2018, share of new leveraged loans issued to the U.S. corporates that had covenants attached was around 23 percent, with LCQI standing at 4.2. Both, the extent of covenants coverage of corporate lending and the quality of covenants have deteriorated to their lowest readings in history.
The story of weak covenants in corporate lending does not end here, however. As was noted by the IMF in a report published in mid-November ( https://blogs.imf.org/2018/11/15/sounding-the-alarm-on-leveraged-lending/?cid=sm-com-TW), weaker covenants underlying corporate loans in recent years “have reportedly allowed borrowers to inflate projections of earnings… to borrow more after the closing” of the M&A and buy-out deals.
The result? “With rising leverage, weakening investor protections, and eroding debt cushions, average recovery rates for defaulted loans have fallen to 69 percent from the pre-crisis average of 82 percent.” Moody’s latest analysis indicates recovery rates even lower, at 61 percent.
Even in the investment grade bonds markets, more than half of all outstanding corporate debt is currently rated BBB, or one to three notches above so-called junk, or sub-investment grade. Not surprisingly, the average yield on investment grade debt is sitting at about 4.4 percent, the highest level since 2010.
One giant canary in the debt mine
Last month, we also witnessed a strong warning from the markets, linked to the continuously rising degree of total leverage and financialization in the economy when the iconic giant of corporate America, GE, experienced a massive sell off on foot of its 3Q financial reporting. At the height of the 2002 to 2007 boom, GE grew to become one of the largest financial and industrial conglomerates in the U.S. history. Today, thanks to decades of mis-investment, financial engineering and debt-funded shares buy-backs, GE is fighting hard to generate positive cash flow. In 1994, GE had total liabilities of $158 billion against total equity of $28 billion. By the second quarter of 2008, these rose to $720 billion, with total equity at $127 billion. A decade later, following aggressive divesting of financial assets, in 3Q 2018, GE had total liabilities of $263 billion with total equity at $48 billion. Put differently, GE’s leverage ratios remained stubborn within 5.5-5.7 range for a good part of two and a half decades, despite a decade-long period of aggressive deleveraging and divestments. Between 2015 and 2017, GE has bought back some $40 billion worth of its own shares, with repurchases taking place at prices of $20 to $32 per share. With GE currently trading at $7.50 a share, the buybacks cost shareholders some $30 billion in value, or nearly four times more money, than the company generated in corporate income.
As an indicator of forward risks, this story is an ominous one. Over the next three years, some 70 percent of currently outstanding corporate debt in the investment grade markets will require roll-over. Increasing scrutiny by the markets of heavily leveraged firms, like GE, if aligned with rising interest rates, can result in investors switching from risk aversion behavior to loss aversion. This can put a hard stop to liquidity supply in corporate assets markets, triggering another financial crisis on par with, if not worse than, the one in 2008.
Debt trap signals a bust
On a macroeconomic scale of things, much of the U.S. corporate sector is an equivalent of Belgium – a country that has been forced to swim harder and harder to stay put in the torrent of debt accumulated back in the early-1980s through the mid-1990s. And this is only the beginning of the underlying leverage risk assessment for the U.S. and the global economy.
Research by the Bank for International Settlements and the IMF shows that across 25 advanced economies, historically, credit booms accompanied by deteriorating credit quality have been followed by three to four years of growth slowing down by 2 percentage point on average. Current debt cycle, in magnitude, suggests a medium-term slowdown of 3 to 4 percentage points, effectively implying a sizeable recession.
And the problem is not restricted to the advanced economies. As the chart below shows, emerging markets are rapidly catching up with the developed economies in terms of real economic debt build up. The chart below shows the dramatic increase in global leverage since the global financial crisis, compared to the decade prior to 2008. See figure 1
This emerging market debt is predominantly denominated in foreign currencies, with pricing linked to the U.S. dollar. This means that the recent strengthening of the U.S. currency is putting severe pressure on corporate borrowers independent of the underlying interest rates changes.
In her G20 comments, Christine Lagarde noted that diffusing the real economic ticking time bomb of debt should be an imperative for developed and emerging economies alike. Alas, after some two decades of loose monetary policies across the globe, the window for action is closing faster than the policy makers capacity to grasp the extent of the problem.