Credit markets join equities as the market slump continues

Chief Economist View 

Just two months ago, the US equity market looked poised for another stellar year of price growth with the S&P 500 up around 10% since January.

Corporate tax cuts, strong corporate earnings growth, and above trend economic growth in the first half of the year had done more than enough to boost investor confidence and overshadow concerns over trade wars, Brexit and a global tightening in monetary policy.

Although markets were volatile over February and March, as the escalation in the trade war between US and China sapped investor confidence, equity markets staged a sustained rally over the five months from April to September that saw the S&P 500 climb by around 15%.

However, this may well prove to be the last period for some time in which financial market conditions are so benign as equities rolled over in October, unable to cope with a bout of higher interest rates, a deteriorating global growth outlook and escalating geo-political concerns.

More recently, attention has also focused on the slide in credit markets, which has focused attention on the level of indebtedness in the US corporate sector risk this poses to financial markets and the economy in a world of rising interest rates and slowing growth.

So how indebted are US corporates? What should we look at?

We know that there are pockets of highly leveraged firms that have suffered sharp credit losses (GE as a recent case). But we are concerned with systematic risk posed by leverage, not idiosyncratic risk associated with individual companies.

For this reason, we first examine the state of business debt in the US at the national level. Here, we find that non-financial business debt is 72.4% of GDP, just a little below its peak during the GFC. Over half of that debt (46.2% of GDP) is held by the corporate sector. 

However, many companies have also built up their cash holdings; particularly tech. companies. Accounting for this, net debt of the non-financial corporate sector as a share of GDP, currently sitting at less than 40%, is below its peak share of GDP during the GFC of around 43%. Scaling by GDP, however, fails to account for the ability of corporates to repay debt.

For some time now, growth in company earnings has been significantly outpaced GDP growth. Net debt to gross operating surplus (i.e., the macroeconomic equivalent to EBITDA) is currently 2.4 times, well below previous peaks.

We also expect companies to take on more debt as their balance sheets expand and asset values have also been rising by more than GDP. This has led to debt to assets ratios of non-financial corporates falling to levels below that seen prior to the crisis and well below their peaks in 1990.

However, while these economy-wide figures provide some comfort, a deeper dive into the data reveals that debt is not evenly distributed across large and small companies with a higher concentration of debt in larger companies.

Taking the 500 companies that compose the S&P 500 equity index, the data show that net debt to EBITDA (at 1.75 times) is above that seen prior to the GFC and its debt to asset ratio is close to its peaks. 

While it seems that economy-wide leverage might not be alarmingly high, larger companies (such as GE) with access to credit markets are leveraging up much more than smaller companies.

Table 1: Financial market movements, 15 – 22 November 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,649.9

-2.9%

US

3.06%

-4.8 bps

US Dollar Index (DXY)

96.71

-0.2%

Nikkei 225

21,646.6

-0.7%

Japan

0.10%

-0.9 bps

USD-JPY

112.95

-0.6%

FTSE 100

6,960.3

-1.1%

UK

1.43%

5.5 bps

GBP-USD

1.288

0.8%

DAX

11,138.5

-1.9%

Germany

0.37%

1.0 bps

EUR-USD

1.140

0.7%

S&P/ASX 200

5,691.3

-0.8%

Australia

2.66%

-5.1 bps

AUD-USD

0.725

-0.3%

Source: Bloomberg

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