Add rising debt to higher interest rates and risks multiply
Inflationary forces lurking in the U.S. could have ripple effects,
At the best of times, it’s difficult to put an accurate conceptual framework around what’s happening in markets and, more importantly, what those happenings augur for the future. So many factors go into it all — macroeconomic forces; fiscal, regulatory and monetary policies; geopolitical events; weather events; mass psychology and individual decisions. There is so much going on that it’s easy to lose sight of the big picture and its effects. That’s especially so this year, when volatility has returned amid — well, so much going on.
So how do you start to paint the big picture?
One place to start would be by looking at the St. Louis Fed’s chart tracking corporate debt in the United States, which could double as the background for an illustrated version of the myth of Sisyphus.
You don’t have to run a regression analysis to see that corporate debt in the States has been growing by about a trillion dollars a year for a while now, and now sits above US$6 trillion. It’s trivial to point out that this is an all-time record, or to point out why it’s happened: money has been cheap, and when money is cheap, people (and corporations) will borrow it.
Now interest rates have risen and look poised to continue. We can say they are still low, but they are rising from historic lows, and that means borrowers will be more sensitive to increases than if rates were already high. And borrowers have way more debt to service than they used to.
It doesn’t exactly allay fears to note the growth of “covenantlite” corporate bond issuances, which lessen protections for lenders — a function of the strong demand for yield in the yield-starved, post-crisis world. And maybe it’s no surprise that, with all that issuance, the median credit rating has declined, but it’s also not much comfort.
Of course, corporate earnings have been strong and the global economy seems to be on a growth course, so all of this might work out just fine. But when this debt starts to roll over amid higher rates, who knows what will happen? The rising tide (of low rates) might have lifted all boats, but rising rates will eventually show which companies can float on their own. And if fixed-income markets seize up (remember when that happened last time?), it might not matter very much.
Even short of that, there’s also the question of what corporations have been doing with that ballooning debt. Much has gone to share buybacks, which as much as investors appreciate them are basically unproductive and do nothing to grow the business.
Then there are mergers and acquisitions. According to Thomson Reuters, more than 50,000 M&A deals occurred in 2017 — the third year in a row that M&A activity hit that mark, which is an unprecedented stretch.
Again, not surprising: Research shows that the more money CEOs have available, the more likely they are to spend it. (They really are just like us.) But that’s not necessarily a good reason to buy another company. Considering that far more than half of M&As fail to provide any shareholder value over the long run, it’s another reason for investors to be wary of the debt hangover.
One reason M&As tend to fail is that buyers tend to overpay. These days, they are overpaying not just because they have a lot of money, but also because asset prices are so high. Which, you know, increases the chances of failure.
I’m singling out U.S. corporate debt, but the issue is obviously not just corporate, and not just American. Canadian household debt, for instance, now stands at $2 trillion, and is more than 100 per cent of GDP. Bank of Canada governor Stephen Poloz has said that the “sheer size” of household debt will have implications for monetary policy for a long time, which implies the bank will be more cautious in raising rates than it otherwise would be.
But for how long ? Inflation seems to be making a return in the form of higher commodity prices. (Which is not a good kind of inflation for consumers.) Meanwhile, in the U.S., the Trump administration’s fiscal policies are stoking inflationary forces.
The Federal Reserve’s rate hiking schedule would contain them, of course — but will it get the pace just right? A policy mistake would not be unprecedented. If inflation runs away in the States, Canada will feel it too, which could have implications for rates here and for the sustainability of consumer debt.
You see the point: The big picture is debt. Whether it’s corporations or consumers we’re looking at, you can fill in the blanks — and what comes out isn’t exactly pretty.