Be assured there will be a next crisis — there always is, sooner or later.
It is the nature of economic cycles that markets get out of balance and have to readjust. That sounds like rather a benign process, but of course we all know there is plenty of pain and many casualties when it happens.
An interesting article in The Economist analyzes the reasons why market crises arise and, from that, where it believes the next one is developing.
To quote the report, financial crises tend to involve one or more of these three ingredients: excessive borrowing, concentrated bets, and a mismatch between assets and liabilities.
The crisis of 2008 was so serious because it involved all three — big bets on structured products linked to the housing market, and bank-balance sheets that were both overstretched and dependent on short-term funding.
The Asian crisis of the late 1990s was the result of companies borrowing too much in dollars when their revenues were in local currency. The dotcom bubble had less serious consequences than either of these because the concentrated bets were in equities; debt did not play a significant part.
As for the next crisis? The Economist report indicates the cause of the next one is probably lurking in corporate debt.
Profits have been growing strongly, The Economist says, and companies in the S&P 500 index are on target for a 25% annual gain once all the results for the first quarter are published. As a result, some companies are rolling in cash but the paper adds plenty are not. In recent decades companies have sought to make their balance-sheets more “efficient” by raising debt and taking advantage of the tax deductibility of interest payments. Businesses with spare cash have tended to use it to buy back shares, either under pressure from activist investors or because doing so will boost the share price (and thus the value of executives’ options).
Low rates have made it easy to take on more debt.
S&P, a credit-rating agency, says that as of 2017, 37% of global companies were highly indebted. That is five percentage points higher than the share in 2007, just before the financial crisis hit. At the same time, more private-equity deals are loading up on lots of debt than at any time since the 2008 crisis.
So, firms are more indebted and yet investors, driven by poor returns on cash, are accepting ever poorer grades of debt as investments. The Economist says the median bond’s rating has dropped steadily since 1980, from A- to BBB-. The corporate-bond market is divided into investment grade (debt with a high credit rating) and speculative, or “junk”, bonds below that level. The dividing line is at the border between BBB- and BB+.
The median bond is now one notch above junk.
Yet, even within investment-grade debt, The Economist reports quality has gone down. According to PIMCO, a fund-management group, in America 48% of such bonds are now rated BBB, up from 25% in the 1990s.
The companies that issue them are also more heavily indebted than they used to be.
In 2000, the net leverage ratio for BBB issuers was 1.7. It is now 2.9. That makes the whole corporate bond market more risky yet; like the housing market in 2006-2007, warnings are going unheeded as the dice get rolled and investors hope this time it will be different.
This is all set against a backdrop of rising 10-year Treasury yield curve, a measure of the Fed’s long-term rate direction. According to The Telegraph, it is now above 3% for the first time since 2014.
With the bull run one of the longest in history and the Fed stepping up plans to tighten monetary policy, some investors will be watching credit markets for signs of trouble. Corporate earnings may be strong at the moment, but this year’s credit market wobbles could prove to be the first tremors before the earthquake, The Economist believes.