Debt owed by nonfinancial corporations (NFC) is at a record high, according to the latest (9/20) Financial Accounts of the United States compiled by the Fed. It rose to $9.4 trillion during Q2 (Fig. 1). This total includes $5.4 trillion in bonds and $3.2 trillion in loans (Fig. 2).
Is this the next bubble to burst, causing the next financial contagion and recession? Each time that Melissa and I have considered the question, we have come to the same conclusion: While there may be reasons to worry about a possible bubble in the NFC debt market, we aren’t overly concerned. (For more, see our 6/19, 7/2, 7/3, and 10/10 Morning Briefings.)
But the story isn’t going away. Last week, the subject made for especially good media fodder for a relatively slow holiday news week. There are mounting worries that the Federal Reserve, by raising interest rates, is steadily eroding companies’ ability to service swollen debt levels. That could turn into especially bad news if the US economy weakens, further squeezing corporate profit margins and depressing cash flow. Nevertheless, we think that most of the debt outstanding should continue to be manageable for firms.
CNBC’s Jeff Cox is a very thorough reporter, and he wrote a very balanced 11/21 article on this subject. It wasn’t alarmist at all, suggesting that the outlook remained fairly bright for corporate credit. Yet his story was titled “A $9 trillion corporate debt bomb is ‘bubbling’ in the US economy.” We are assuming his editor decided the article would attract more readers if the title implied that there’s a big bomb in the credit markets. Given the traumatic impact of the last financial crisis, it’s easy to scare people into thinking that a repeat of the calamity, perhaps one that’s even worse than the last, is on its way.
Of particular concern are collateralized loan obligations (CLOs). The Fed’s quarterly data show NFC loans at depository institutions and those not classified elsewhere. Presumably, the latter category counts loans made by the shadow banking system including CLOs. During Q2, NFCs’ bank loans rose $54 billion y/y to a record $1.1 trillion (Fig. 3). NFCs’ other loans jumped $267 billion y/y to a record $1.5 trillion.
“I am worried about the systemic risks associated with these loans,” said former Fed Chair Janet Yellen in a 10/25 interview with the Financial Times. “There has been a huge deterioration in standards; covenants have been loosened in leveraged lending,” she added. Yellen suggested that the US needs to focus on fixing weaknesses in the system rather than going in a “very deregulatory direction.”
Her main concern is that while banks may be well capitalized against leveraged loans, the debt is being repackaged and sold elsewhere. She added: “If we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt. It would probably worsen a downturn.”
Senator Elizabeth Warren (D-MA) echoed Yellen’s remarks during an 11/15 congressional hearing. “The Fed dropped the ball before the 2008 crisis by ignoring the risks in the subprime mortgage market,” Warren said. “What are you doing differently this time in coordination with other federal regulators so that you’re limiting the risk that leveraged loans cause serious harm to the financial system?”
Warren addressed her question to Fed Governor Randal Quarles, vice chairman for supervision and thus the central bank’s leading bank regulator. He responded rather lamely, saying that banks received “guidance” on the issue several years ago and that it’s not the central bank’s duty to “enforce” something that was not codified as a rule. “We are holding them to standards of safety and soundness,” he said. “We are not in any way abrogating or not looking at leveraged lending.”
Are there really bombs in the debt markets? Before we address this question in the following three sections, let’s review some of the economic indicators confirming that the US economy remains strong and that, while corporate profits growth is bound to slow, it will do so as it continues to rise to record highs.
Consider the following:
(1) Truck tonnage and railcar loadings. During October, the ATA Truck Freight Index soared 9.5% y/y to yet another record high (Fig. 4). There’s no sign that a shortage of truck drivers is hampering the trucking industry from delivering the goods. Similarly, intermodal railcar loadings soared to a record high in the 11/17 week (Fig. 5). The y/y growth rate of this series (using the 26-week average) is highly correlated with the comparable growth rate in industrial production. The former is up 4.4%, while the latter rose 4.1% during October.
(2) Regional business surveys. So far, November regional business surveys are available for four Fed district banks. The average of their composite business indicators fell during November, but remained around the elevated levels since Election Day 2016 (Fig. 6).
(3) Forward revenues. S&P 500 forward revenues rose 9.7% y/y to yet another record high during the 11/15 week (Fig. 7). This weekly series, reflecting industry analysts’ consensus expectations, is a very good coincident indicator of actual quarterly S&P 500 revenues, which may be rising to yet another new record high during the current quarter.
Bargains scooped up by distressed asset funds, of course, expose someone to big hits. This time, it probably won’t be the banks. More likely, the losses will simply reduce the rates of return among some large institutional investors and perhaps some bond funds (including exchange-traded funds), ending there.
In other words, the odds of a systemic calamity like we saw in 2008 remain low, in our opinion.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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