Analysts are becoming worried about high levels of US corporate debt before an expected monetary tightening cycle. Photo: Getty
Debt in corporate United States has exploded following seven years of virtually zero official interest rates, raising fears about the potential impact on the sector of the mooted hike by the US Federal Reserve in December.
A rise in US bond yields will push domestic and global funding costs higher, Morgan Stanley strategists wrote in a note to clients. This does not bode well for domestic US corporates who have seen debt levels rise over recent years.
They note that US businesses have mostly used cheap credit to buy back shares, as well as to fund merger and acquisition activity, pushing corporate debt as a percentage of gross domestic product towards historically elevated levels .
A rise in Fed rates will push funding costs higher and likely curb this activity, they say, pointing to evidence that lending standards for US businesses have already tightened.
In what could lead to a potential negative feedback loop, a member of the US Fed’s monetary policy setting committee has indicated rates might need to go up faster to contain risks associated with the rapid growth in higher-risk lending.
Boston Federal Reserve chief Eric Rosengren told the Financial Times at the weekend interest rates might need to rise a little more quickly should the bullish trends in commercial property and risk taking in parts of corporate lending continue.
Rosengren, a voting member of the Federal Open Market Committee, which sets US monetary policy, has in the past advocated a more cautious approach to raising rates than some of his peers. But he said that should current trends in commercial real estate and large syndicated loans continue, that would be a reason to maybe think about raising rates a little more quickly than I otherwise would, given the same unemployment and inflation rate .
Tightening cycle too late
Meanwhile, the imminent Federal Reserve tightening cycle is too late , Societe Generale global strategist Albert Edwards – a renowned bear , or pessimist – wrote in a note to clients late last week. Edwards warned that net debt has exploded and that the promiscuous US corporate sector behaviour is already way out of control .
He points out that while bank lending in the United States has taken off, little has flowed through to real economic activity, which has resulted in the central bank diverging from its usual path of tightening rates to moderate credit growth.
The primary driver for the rapid rise in bank lending has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity-expanding expenditures, but rather to buy back mountains of their own shares.
As a result of borrowing to fund unproductive activity, net debt in American businesses now massively exceeds aggregate earnings before interest, tax, depreciation and amortisation, Edwards says.
On US Federal Reserve data, Edwards says corporate debt borrowing is growing by $US674 billion ($948.1 billion) a year annual rate, closing on the all-time borrowing splurge of 2007 of about $US800 billion a year.
He believes the US Federal Reserve has repeated the sins of the past and left rates too low for too long and blown a bubble it will struggle to contain as US businesses grapple with the monetary tightening cycle.
Teed up for another crisis
Once again, companies have chosen to waste their money buying their own shares at top-of-the-cycle valuations, he says. We are nicely teed up for another crisis.
Rather than seeing a massive blow-up in the corporate credit market, the Morgan Stanley team see the elevated debt levels in corporate US as another reason to be cautious on the outlook for US equities, alongside tightening margins and the hit to offshore earnings from a stronger greenback – another big implication of higher US rates.
The Morgan Stanley analysts also point to another issue that is associated with rather than as a result of tighter US monetary policy: accelerating wage growth.
Wage growth, which has so far been absent from the US recovery, emerged last week – average hourly earnings rose to a six-year high.
Higher wages and broad jobs creation will clearly benefit the consumer and should support top-line earnings. However, they will also cut into margins, they write. On Monday, Credit Suisse analysts warned of the risk of stronger-than-expected inflation.
In a rising rate environment we expect bonds to underperform, emerging market and commodity-linked currencies to come under renewed selling pressure, and US equities to face growing headwinds.
The Morgan Stanley team tactically moved underweight Australian equities in early August, while moving overweight cash, adding a bet on a rising US dollar against the Aussie dollar, while reducing passive exchange-traded fund equity exposure within their (overweight) international equity allocation.
For the record, Edwards’ global asset allocation settings looks like this: 30 per cent equities, 50 per cent bonds and 20 per cent cash.