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The $4 Trillion Dog That Refused To Bark

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by: The Heisenberg
Summary

If Heisenberg's a "chicken little," then so too is the IMF.

Because Christine Lagarde and co. are out warning about runaway leverage.

Oh, and one bank is calling that very same leverage a giant "bubble.".

There are some pretty shocking things in here for anyone who cares to look.

More than a few (dozen) readers have accused me (Heisenberg) of being "the boy who cried wolf" or, alternatively, a "chicken little."

The first thing I would say to those folks is this: there are more creative ways to express that sentiment than resorting to the tired old children's story references.

But beyond that, I'm not entirely sure that's a fair characterization. No one calls meteorologists "chicken littles" when they warn people about a thunderstorm that doesn't end up happening (well, Matt Drudge does, but let's leave him out of this).

Can you imagine calling in to your local television station and demanding answers from the weather guy when his storm warning prompted you to bring an umbrella you didn't end up needing? "This chicken little needs to be fired immediately!"

It kinda seems like being warned about risks that don't materialize is far preferable to the opposite, right? I mean you wouldn't call in to the network if a forecasted thunderstorm doesn't occur, but you very well might demand some answers if the weather guy, for fear of being called "chicken little," fails to mention that a hurricane may be on the way.

Anyway, I wasn't going to write anything else for this platform today, but I decided to take a brief break from HR to pen something brief on a risk that I actually think is something you really should be concerned about.

That's not to say the other things I warn about shouldn't concern you. It's just that this is a really straightforward assessment of what certainly looks like a really easy-to-understand problem (and one I've been pounding the table on for something like 8 months).

If you haven't skimmed the IMF's latest report on global financial stability, you probably should. Unlike a lot of what I cite, it's publicly available. You can download the whole thing here.

You know how I'm always talking about corporate leverage rising and how low interest rates are tempting firms to issue debt for the sole purpose of buying back shares, etc.? Yeah, well check this out from the IMF report linked above (my highlights):

The corporate sector has tended to favor debt financing, with $7.8 trillion in debt and other liabilities added since 2010 (Figure 1.8, panel 3). Bank lending to the corporate sector has continued to recover and could well rise further in response to more favorable market valuations (Figure 1.8, panel 4). In contrast, equity finance has traditionally been outstripped by share buybacks and has recently leveled off (Figure 1.8, panel 5). A drop in the cost of equity capital may stimulate equity financing, but it could coincide with higher corporate debt (Figure 1.8, panel 6)-particularly if additional share buybacks are financed through debt.

There has been a stronger reliance on debt financing as the credit cycle entered a mature phase. Corporate credit fundamentals have started to weaken (Figure 1.9, panel 1), creating conditions that have historically preceded a credit cycle downturn (Figure 1.9, panel 2). Asset quality-measured, for example, by the share of deals with weaker covenants-has deteriorated. At the same time, a rising share of rating downgrades suggests rising credit risks in a number of industries, including energy and related firms in the context of oil price adjustments and also in capital goods and health care.

Also consistent with this late stage in the credit cycle, corporate sector leverage has risen to elevated levels. Median net debt across S&P 500 firms- which collectively account for about one-third of the $36 trillion economy-wide corporate sector balance sheet-is close to a historic high of more than 1½ times earnings (Figure 1.9, panel 3). A look beyond the S&P 500, at a broader set of nearly 4,000 firms accounting for about half of the economy-wide corporate sector balance sheet, suggests a similar rise in leverage across almost all sectors to levels exceeding those prevailing just before the global financial crisis (Figure 1.9, panel 4).

None of that is good. And importantly, none of that is really refutable. Not to put too fine a point on it, but that chart in the bottom-right pane in fact looks really, really bad. Actually, the chart in the bottom-left pane looks really bad too. Again, that's net leverage for all S&P 500 (NYSEARCA:SPY) companies - and it's nearing record highs.

So if you actually read all of the above, the next logical question is this: "oh God, what happens to this dynamic if rates rise?" Well, here's what the IMF has to say on that (my highlights):

As leverage has risen, so too has the proportion of income devoted to debt servicing, notwithstanding low benchmark borrowing costs (Figure 1.10, panel 1). Although the absolute level of debt servicing as a proportion of income is low relative to what it was during the global financial crisis, the 4 percentage point rise has brought it to its highest level since 2010, which leaves firms vulnerable to tighter borrowing conditions. The average interest coverage ratio-a measure of the ability for current earnings to cover interest expenses- has fallen sharply over the past two years. Earnings have dropped to less than six times interest expense, close to the weakest multiple since the onset of the global financial crisis (Figure 1.10, panel 2). Historically, deterioration of the interest coverage ratio corresponds with eventual widening in credit spreads for risky corporate debt (Figure 1.10, panel 3).

Under the adverse scenario in Scenario Box 1.1 of the WEO, an unproductive fiscal expansion could lead to a sharp rise in borrowing costs. Such a sharp rise in interest rates amid tepid earnings growth could further compromise the ability of firms to service their debt (Figure 1.10, panel 4). Under this scenario, the combined assets of challenged firms could reach almost $4 trillion. The number of firms with very low interest coverage ratios-a common signal of distress-is already high: currently, firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (Figure 1.10, panel 5). This figure doubles to 20 percent of corporate assets when considering firms that have slightly higher earnings cover for interest payments, and rises to 22 percent under the assumed interest rate rise.

You got that, right? That's the IMF telling you that we may have a $4 trillion problem in a rising interest rate environment.

Do me a favor, will you? Look at the chart in the upper-left-hand corner above. See how the IMF is saying corporate credit spreads (NYSEARCA:HYG) have become disconnected from corporate leverage? Ok, now refer back to one of the most popular pieces I've ever written on this platform called "This Trade Is Over. Done With. Kaput." That's exactly what I was trying to communicate in that post.

Well lest you should think it's just the IMF that thinks this is an issue, consider this out Monday morning from SocGen (my highlights):

Global equity markets have gone nowhere for the last couple of months. Politics is highlighted as the main barrier to further progress with Trump yet to deliver on many of his election promises and European investors concerned about the outcome of the French election. With the latter seemingly out of the way, markets are responding positively, much in the same way the Russell 2000 bounced post Trump. We have no political expertise but nonetheless recognise the palpable relief but we also understand the real problem for equities worldwide is one of high valuations, high expectations, yet still lacklustre growth and ever worrying and mounting levels of leverage. As with Trump any euphoria surrounding Macron will rapidly turn to a focus on delivery.

Regular readers will know will have been flagging the US debt issue for a long-time. But for many it is the dog that refuses to bark.

The problem the US now faces is it has to normalise interest rates, but with the smallest 50% of companies already spending 30% of profits (and at peak EBIT) on interest rate costs, any move upwards is likely to push up interest costs to dangerous levels. If EBIT was also to fall as a consequence, a large number of US companies could quickly find themselves in trouble. But if you fail to normalise rates, what is going to stop US corporates taking on even more debt?

Read that again: "the smallest 50% of companies are already spending 30% of their profits" servicing their debt.

If rates rise, they're doomed. If rates don't rise, they'll lever up even further.

Just to drive the point home, allow me to show you what the title of that SocGen note is:

So "who will burst this bubble?"

It's a good question. And one you should consider carefully because remember, this is the US corporate sector we're talking about here or, in other words, "the companies you (literally) own" via your stock holdings.

But who knows, maybe this can continue because as SocGen notes, this has so far been "the dog that refuses to bark."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.