Swatting at the Recession Story Flies. Now It’s (Pun Alert) Buzziness Debt.

Nov 27, 2018 by Gary Gordon

I find myself in a weird place.  Most who know me consider me a cranky pessimist.  All because I constantly point out the human tendency to overborrow, a habit that frequently leads to bad results.  And I love to short stocks.  And other stuff negative stuff.  OK, I’ve got a problem.

But the analysis I’ve developed to study the role of debt in economies leaves me relatively optimistic for the US for the next few years (see my last blog post for the argument).  So with the drumbeat call for a recession mounting daily, I’m in the odd position of being bullish on the economy and the stock market while others are worrying.

The media scramble to spot the coming recession recently turned to business debt.  This morning The New York Times published an opinion piece entitled "Big Debts, Bigger Worries" that addressed this topic.  And recently CNBC put out this alert:

“A $9 trillion corporate debt bomb is 'bubbling' in the US economy…Stocks are floundering, credit spreads are blowing out and concern is building that a combination of higher interest rates on all that debt will begin to weigh meaningfully on corporate profit margins.’”  (November 21, 2018)

Pretty damning evidence, eh?  A “debt bomb” about to explode and wipe out the Free World, or at least the parts of the Free World holding financial assets.  But I seek facts, not hyperbole.  So let’s check out the facts relevant to CNBC’s claims.  I start with…

…”A $9 trillion corporate debt bomb”

$9 billion is a lot of debt.  But a debt level is only relevant when compared to the income expected to service it.  The standard income measure for a national debt statistic is GDP.  Here’s the comparison:

 

Sources: Federal Reserve, Bureau of Economic Analysis (BEA)

This looks bad for me; the ratio just set a new high.  But let’s compare the corporate debt to an even more relevant income measure, namely corporate profits:

 

Sources: Federal Reserve, Bureau of Economic Analysis (BEA)

A surge in business profit margins since 2010 has given corporations far more capacity to service debt.  So far, then, so good.

“Stocks are floundering”

OK, got me there.  Stocks are floundering.  But stocks represent just a forecast of future earnings, not a fact.  So not damning evidence.

“Credit spreads are blowing out”

Yes, the spread between a junk bond yield and a similar maturity government bond yield widened by 0.75% over the past few months.  Yes, investors are more worried about corporate bond defaults.  But how does the current 4.25% spread compare to history?  FRED, the fabulous economic data service of the St. Louis Federal Reserve, provides this answer:

 

Source: ICE Benchmark Administration Limited, via FRED

The 75 basis point widening now looks like a little pimple.  Investors have lost their over-confidence, that’s all.  They remain optimistic about even high-risk junk bond defaults.

“But what about the increasing riskiness of new corporate debt?”

CNBC missed this worry, so I graciously add it.  This chart illustrates that a growing share of new debt issuance is of low quality:

 

That’s a fact.  I can’t wiggle out of this one.  But I have to add a very important subtlety.  CNBC linked the “debt bomb” to the US economy.  Makes sense – the more businesses borrow, the more they spend, right?  And reduced debt issuance should slow the economy, right? 

No, not necessarily right.  Businesses borrow not only to finance investment spending (buildings, equipment and inventory), but to finance acquisitions.  And acquisitions not only of other companies, but of their own companies, through share repurchases.  So it is important to identify how much corporate debt issuance is really important to the economy – that which finances investment spending – and that which just shifts equity ownership.  There are no hard facts to answer that questions, but there are clues, namely private equity and share repurchase activity.

Private equity deal making continues to be strong, as this chart shows:

 

Similarly for share repurchases.  As an example, it’s hard to believe, but Apple Inc. had $106 billion in debt outstanding at the end of September, 2018.  Huh?  Apple generated a total of $116 billion of free cash flow over the past two years.  But the company not only gave $26 billion of that cash to investors as dividends, but spent $106 billion to buy back its stock, necessitating borrowing.  And Apple is not alone.  This chart shows Corporate America’s growing share repurchases, especially since the 2018 tax cuts:

 


In sum, a lot of corporate debt issuance over the past few years is “economy-lite” and won’t cause a recession if it recedes.

Finally, “higher interest rates on all that debt will begin to weigh meaningfully on corporate profit margins”.

Sorry, but no, the numbers don’t work.  According to the BEA, Corporate America is currently earning $2.0 trillion a year.  A one percentage point increase in debt costs after tax is $74 billion, or less than 4% of earnings.  And because a good deal of corporate debt is fixed rate, that cost would be phased in over a few years.  Pretty close to a rounding error.  And I guarantee that the Federal Reserve will only keep raising interest rates if GDP is healthy, which means company earnings would be healthy. 

Wrapping up…

US corporate debt is far from a “bomb” waiting to take the US economy down in a fiery blaze.  Corporate losses were only 0.26% of bank loans during the 2018 third quarter, less than half the long-term median.  And they have declined over the past year.

You’ve got other things to worry about.  Don’t worry about corporate debt.  And consider buying some beaten-up stocks.