Very high and rising levels of corporate debt in the major economies have been troubling central banks and regulators for several years, but until now there has been little willingness to take direct policy measures to reduce the associated financial risks.
Last week, however, the IMF issued a strong warning that action is “urgently” needed to head off the danger of a financial meltdown in the corporate sector, which could potentially spread into the banking and shadow banking sectors. Policymakers and investors should pay close attention.
Among the three largest economies, the IMF argues, the eurozone is currently the least at risk of a major collapse in its corporate sector, largely because it addressed some of the problems of excess debt after the euro crisis in 2012. In China, these problems would become severe in a recession, but the policy response is already under way.
That leaves the US, where corporate debt continues to rise extremely rapidly and could be stimulated further by the latest interest rate reductions by the Federal Reserve.
I argued in March that this problem was not yet dangerous, but that was probably too complacent.
Although US corporate debt-to-income ratios were already close to all-time peaks, other aspects of company balance sheets and financial flows were in much better shape. Profit margins were still fairly robust, the net financial balance of the corporate sector was in comfortable surplus, interest-to-income ratios were low and debt-to-equity ratios were healthy.
The one major cause for concern was the distribution of debt within the company sector, especially the growth of the $1tn leveraged loan market.
In the last six months, the condition of US corporate finances has become more worrying. As in other major economies, profit margins have come under increasing downward pressure, because producers’ wage costs have been rising more rapidly than selling prices to the consumer. The Phillips curve relationship between declining unemployment and rising inflation has been working well in the wages sector, but not at all in the prices sector.
The deterioration in profits growth (see box below) has been accompanied by more aggressive corporate financial behaviour, while real capital investment to expand productive capacity has been cut back. According to the IMF stability report, share buybacks, dividends and merger and acquisition activities — financed by leveraged loans and high-yield bonds — have surged in 2019. These activities have spread to small and medium-sized firms, which the IMF says are particularly vulnerable on the profit front.
Taken in isolation from other economic shocks, such corporate financial weaknesses are unlikely to trigger a recession, but they could certainly exacerbate the effects of other contractionary shocks. This is what happened in 2008, when a medium-sized shock in the subprime mortgage market caused an enormous downturn in economic activity. The impact of the trade disputes on business confidence, which has been collapsing in recent months, is the most obvious current threat.
The Federal Reserve and other US regulators have left it rather late to acknowledge these risks. Fortunately, there are some indications that they are now preparing to act.
In a speech on 25 September, Fed governor Lael Brainard said that financial vulnerabilities in the corporate sector have been increasing markedly, and specifically mentioned that the central bank will decide whether to activate its countercyclical capital buffer in November.
This mechanism enables the Fed to require the nation’s largest banks to increase capital buffers against the time when economic stresses emerge.
Following Ms Brainard’s remarks, it would be surprising if the Fed’s annual vote on the buffer in November fails to impose higher capital charges on large banks. That would be a move in the right direction, but it would leave potential problems in the regional banks, and the shadow banking sector, largely untouched.
The Fed needs to show more urgency in these areas, before it is too late.
As a result of shrinking profit margins and slowing revenue growth, earnings for S&P 500 companies are now estimated to have fallen slightly in the past 12 months, down from 20 per cent growth in 2018. Furthermore, earnings growth for the large quoted companies contained in the S&P 500, including foreign profits, has been much higher than the figure for the entire company sector in the domestic economy, shown in the gross domestic product accounts issued by the Bureau for Economic Analysis.
These official figures show that US profits have risen by only 6 per cent in the last three years, compared with an increase of 50 per cent for the S&P 500.
The difference could be partly explained by the fact that the latter number may be inflated by the inclusion of capital gains on company investments, which are driven by the rising stock market.
This implies that S&P 500 profits may automatically be hit if the equity market declines, establishing a negative feedback loop in company finances.