The Next Financial Crisis – Corporate Debt?

Feb 13, 2019

The national debt gets all the headlines, but what about corporate debt?

You hear a lot of worrying about mounting government debt because many people are convinced that public debt is a main source of problems for any economy. And by mid-February 2019, the US might reach its debt ceiling, which is a legislative limit on the amount of national debt that can be incurred by the US Treasury, essentially limiting how much money the federal government can borrow.

But proof that the growth of government debt leads to disaster is weak.

This sentiment reached hysterical levels in the US in 2010, when even the chairman of the U.S., Joint Chiefs of Staff, four-star Admiral Mike Mullen, called public debt the “biggest threat to national security.” Debt fights culminated in a government shutdown that resulted in Standard & Poor’s stripping the US of its AAA rating. This repugnance to government debt remains unabated in many circles.

The evidence, in fact, points in the other direction: Economic and financial disasters precede, rather than follow, a surge of public debt.

More worrisome for investors, however, is that there might be a real lurking danger in soaring private sector debt, here and abroad. That could be where the next debt crisis might come from.

Consider This

Total net government debt in the US went from $5.1 trillion in 2007 to $9.4 trillion in 2010 – an increase of more than 80%. Why? Because entire business sectors, mostly financial, were at the brink of collapse and the government had to bail them out.

This meant Washington ended up adding a vast amount of that debt – which it took on directly, or indirectly by guaranteeing liabilities or injecting capital.

The size of U.S. government market debt actually declined during the time when financial sector liabilities doubled. The government debt growth came later, and mirrored the financial services industry’s decline. And the financial crisis from that time period has led to our national debt standing at about $21 trillion today.

Percentage of GDP

The United States recorded a government debt equivalent to 106% of our Gross Domestic Product at the end of 2018. Government Debt to GDP in the United States averaged 61.70% from 1940 until 2017, reaching an all-time high of 118.90% in 1946 and a record low of 31.70% in 1981.

But just like your personal credit card debt, while the size of the debt matters, the ability to make the payments is even more important.

Consider this; Japan has government debt that has consistently remained north of 200% of its GDP, but most of its debt was held by its own citizens, which has greatly reduced the risk of defaulting. Ukraine, on the other hand, defaulted when its debt was 30% of its GDP.

A similar thing happened to Spain, which saw government debt explode from 36% to 100% of GDP. Government debt declined while private debt grew until it became too large to handle. Eventually, the government was forced to take it over to prevent an economic collapse.

The Lesson

The lesson here is that huge run-ups in public debt levels are often a consequence of economic problems rather than a cause. The place to look for signs of future trouble is the private sector.

Unfortunately, by this measure the world seems to be in a much worse place today than before the financial crisis. Driven by historically low interest rates, private corporations have accumulated very large amounts of debt in the last few years, and much of it is in the form of corporate bonds.

The Danger

Looking at the increase of non-financial corporate debt in the US, the current expansion is the largest and fastest on record. And in the last few decades, similar expansions were followed by large and damaging crises.

How many investors know that the total debt of nonfinancial corporations has more than doubled over the past decade, growing by $37 trillion to reach more than $66 trillion – a growth rate nearly equal to the increase in government debt, which has received far more attention?

What makes matters worse is that this problem is not confined to the US In fact, some estimates suggest that emerging-market private sector debt has increased by an enormous 50% of GDP since before the financial crisis. It seems quite likely that today’s emerging-market private debt will become government debt when the next crisis comes along.

It is not surprising that the global debt of the private sector is growing so rapidly everywhere. Interest rates are still at historically low levels. And the incentive to borrow is huge.

This state of affairs is unlikely to last. Unless deflation – or disinflation – persists for far longer than anyone can imagine, interest rates will rise and the market price of debt will fall. This can trigger a large wave of selling, depending on the market’s perception of how fast rates can go up. Too many sellers and few buyers could lead to a new debt-related crisis.

The risk has not gone completely unnoticed. A few market economists have issued warnings, but so far the general level of concern is very low.

What to Do?

Trying to protect portfolios by diversifying holdings among various sectors will not help in a real debt crisis. Whenever panic strikes, correlations escalate – meaning even disparate assets behave alike. That happened in 2008, when there were few places other than Treasuries to ride out the cataclysm.

The best course is to develop a plan for what to do if market conditions take a sharp turn for the worse. This means having pre-planned exit points to limit the damage and prevent over-reactions. It also means developing a plan for re-entry after the storm that triggered those exit points has passed.

Maybe there is no crisis lurking just around the corner. Maybe interest rates won’t go up soon, or much. But a private-debt related crisis be triggered for other reasons, such as credit-quality concerns. And given its gigantic growth, conditions for a debt-led crisis are lining up better than at any time in recent years.

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By John Rothe, CMT

Founder & Chief Investment Officer

Riverbend Investment Management

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