First Came Brexit. Next Comes Crexit?

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Brits sent shockwaves throughout financial markets in June when they approved the referendum to exit the European Union. Since then, concerns have also surfaced that corporate debt is rising everywhere, giving us "Crexit," a mashup of the twin risks of Brexit and credit.

Global corporate debt jumps

Standard & Poor's recently voiced concerns that, "heightened sensitivity to unexpected developments similar to the UK's referendum to leave the European Union could lead to a crisis of confidence and rapid departure of both lenders and lower-quality borrowers from the debt markets."[1]

Corporate debt has climbed because borrowing has been cheap and global central banks are likely to keep rates low. Too much borrowing, however, could spell widespread trouble unless credit quality remains high, economic growth continues and inflation and interest rates stay low.[2]

S&P predicts global corporate debt which stood last year at $51.4 trillion could ramp up to $62 trillion by the year 2020 and $75 trillion by 2021, a 21 percent rise. China is predicted to be the largest borrower accounting for about 45 percent of this debt followed by the U.S. at 22 percent and Europe at 15 percent.[3]

The Fed continues to keep interest rates low. Shaded areas represent U.S. recessions. Source: FRED

Worse-case scenario

If the Federal Reserve raises rates and the U.S. economy slows, many businesses could struggle to manage their growing debt effectively as some are likely to suffer when the economy is doing poorly.

Investors could take a hit too if stock valuations drop and debt becomes more expensive. Actions like rolling over bonds or refinancing loans are harder to do when rates go up and inflation increases.

If borrowers start defaulting on their loans, many lenders could decide to pull out of the market and this sudden tightening could set off another financial panic, i.e. Crexit.

What's the worst that could happen? According to Standard & Poor's, it would be a

series of major negative surprises sparking a crisis of confidence around the globe. These unforeseen events could quickly destabilize the market, pushing investors and lenders to exit riskier positions.

In addition, S&P thinks some degree of a credit market correction is inevitable because the growth of corporate borrowing has outpaced that of the global economy and the actions of monetary policy so far have been increasing financial risk.[4]

More leverage, more defaults

Not only are a lot of companies borrowing money, many of them are already highly leveraged. For example, about 50 percent of companies within the financial sector carry significantly more debt than equity. When companies increase their leverage, not only do they become riskier investments, they are more likely to go into default. Close to 5 percent of the financial sector has negative cash flows or earnings today and it's possible that this ratio could rise.[5]

There have been 100 corporate bond defaults so far this year. That's 50 percent higher than they were a year ago, largely thanks to volatility in financial markets and slumping prices of oil and other commodities. No doubt energy and natural resources businesses accounted for a majority of defaults this year. This has led some analysts to predict a spillover effect into other sectors in the upcoming quarters.[6]

Note that corporate defaults are up 87 percent from last year with the U.S. behind many of them.

Many investors, however, do not appear to be aware of the rising bond defaults. Fixed-income funds are at their highest levels since February 2015 with trading volumes for corporate bonds up double digits amongst investment-grade and high-yield bonds.[7]

Global corporate defaults are on the rise with the U.S. leading the way. Source: Financial Times

You may want to look before you leap

If the credit crisis predictions are correct, things could get a whole lot worse before they get better.

Take some time to review your portfolio. Start paying close attention to how the companies you're invested in or eying are managing their balance sheets and cash flow. Are they becoming more leveraged? Are they at risk of default? Did they meet, beat or disappoint their latest earnings results?

Blue chips and other companies with large balance sheets and strong operating cash flow should outperform in a Crexit scenario.

The Cash Flow Kings motif includes companies with some of the lowest Enterprise Value to Free Cash Flow ratios for the past four quarters. As of August 1s its 1-year return is 12.4 percent.

The Dividend Stars motif includes companies with a track record of not cutting dividends for at least 25 consecutive years while growing in the prior year and has a 1-year return of 16 percent as of August 1st.

The Stable Earnings motif is focused on companies that are less impacted by economic downturns and command higher valuations versus their peers. The motif has a 1-year return of 13.4 percent as of August 1st.

[1] Stone, Amey, “As corporate debt surges, get ready for ‘Crexit,’ warns S&P,” Barrons, July 20, 2016.

[2] Stone, Amey, “As corporate debt surges, get ready for ‘Crexit,’ warns S&P,” Barrons, July 20, 2016.

[3] Cox, Jeff, “Corporate debt seen ballooning to $75 trillion: S&P,” CNBC, July 20, 2016.

[4] Cox, Jeff, “Corporate debt seen ballooning to $75 trillion: S&P,” CNBC, July 20, 2016.

[5] Cox, Jeff, “Corporate debt seen ballooning to $75 trillion: S&P,” CNBC, July 20, 2016.

[6] Cox, Jeff, “Corporate bond defaults cross 100, highest level since crisis,” CNBC, July 14, 2016.

[7] Cox, Jeff, “Corporate bond defaults cross 100, highest level since crisis,” CNBC, July 14, 2016.

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