Global corporations have enjoyed a strong decade of gains and earnings increases, in large part due to a huge accumulation of debt. In 2010, the debt of large US corporations sat at just over $6 trillion USD; now that number has risen above $10 trillion USD and when you add in the debt of small, medium, and family enterprises, that number rises to $15.5 trillion USD.
The problem with those numbers is that a lot of that money has been spent on things like share buybacks and dividends, as opposed to increases in productive capacity. And while low interest rates and consistent earnings have made the high debt levels serviceable, should earnings decline, many companies may not be able to afford their repayments.
While the effects of the virus on an economy may not seem immediate, consider that oil prices fell around 20 percent last week. If you are a marginal oil producer with a high debt load, the ability of your business to service that debt becomes much more difficult. Marginal commodity producers may therefore be some of the first businesses facing the threat of bankruptcy.
Next in line would likely be tourism, travel, shipping, and logistics related businesses, who are likely see massive sales reductions due to the reduction in travel and shipping due to the shutdowns and drop in demand for travel from the coronavirus. After that we are likely to see the flow on effects do damage to lenders and debt investing companies. The banks and financial institutions necessary to keep the lending markets pumping. Enough defaults on the debt that they hold will threaten their ability to pay back their own borrowing.
A lot of US corporate debt is rated “BBB”, which is the lowest “investment grade” a bond can reach. This grade makes up over 50% of all investment grade corporate debt. Should these bonds be downgraded to “BB+” or lower, they would drop out of an “investment grade” and move to a “speculative” or “junk” classification, and raising additional funds would be much more difficult – this can include refinancing to benefit from a drop in interest rates.
Many investors may also have an investment mandate that would force them to sell non-investment grade bonds, which could lead to a liquidity crisis should enough bonds be de-rated. Should this situation occur – it would create huge difficulties for any company looking to borrow – devaluing both their debt and equity.
While the correlation between economic growth and stock market performance isn’t always that strong, if there is a large hit to corporate earnings due to the virus, there is the possibility of debt related economic consequences for the heavily leverage US corporate sector.
Our own corporate debt levels aren’t quite as high, but our household debt levels are extraordinary. Should the virus lead to increases in domestic unemployment – this would be a massive threat to the Australian economy.
While the encouragement of monetary (and indeed fiscal) authorities to borrow more money has certainly helped risk asset prices in the short-term. The additional levels of debt that this encouragement has caused poses a threat to the global financial system.
Sam Green is the Portfolio Manager at Emerald Financial, whilst also being an Equities and Derivatives expert for his clients at TradersCircle.
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