The Fed recently restored market confidence that low rates will be there to support economic growth. That’s exactly the problem on a longer-term basis, UBS says.
Stocks continued to rise Tuesday after Federal Reserve Chairman Jerome Powell continued to restore investors’ confidence in the current economic expansion. But how long does the U.S. economy have before the low-rate environment causes an implosion?
Powell said in his testimony before Congress that “the current stance of monetary policy will likely remain appropriate,” implying that the Fed will lower interest rates if the economy needs it.
Of course, investors are now more optimistic that the U.S. and China will reach a comprehensive trade deal. But Powell said the Fed is monitoring the potential impact on the U.S. economy of the coronavirus.
But with low interest rates powering economic expansion and the stock market, a longer-term risk – the U.S. debt-to-GDP level – is beginning to look scarier.
Data from both the St. Louis Federal Reserve and UBS’s office of global wealth management shows that U.S. corporate non-financial debt was 46.5% of GDP in 2019. In simpler terms, in 2019, 46 cents of corporate non-financial debt was outstanding for every dollar of productivity in the U.S.
That ratio is higher than it was just before the financial crisis that caused the Great Recession, when debt-to-GDP was 45.5%. When everything came crashing down, the ratio eased to roughly 38% by 2010. But the debt level steadily rose throughout the current economic expansion, reaching a hair above 45% by 2017.
In 2018, the Federal Reserve raised interest rates as the economy was running hotter than ever before in the expansion, with GDP just under 18% for one quarter and inflation running at around 2% (below 2% now). Stocks sold off as investors feared the rate hikes would choke off growth. And debt-to-GDP fell back toward 45%.
But after three rate cuts in 2019, companies rushed to refinance their debt and borrow more money. The ratio is now at its highest since 1995, UBS’s graph shows.
A higher debt burden means that if the GDP side of the equation falls off, companies may have trouble paying back their lenders. If credit defaults ensue, banks could have a liquidity event. This could put an economy running currently at around 2% into a shock. A recession could follow.
“Loose financial conditions in a late-cycle economy often bear unintended side effects: Asset bubbles tend to form more easily, and aggregate debt levels keep rising to unsustainable levels,” UBS wrote in its note.
"In the long run, this makes the economy more vulnerable to both internal and external shocks, which can range from rapid changes in interest rates, to market-unfriendly political outcomes, to any number of unknown unknowns.”
Ray Dalio, the founder of hedge fund Bridgewater Associates who is renowned for his stock-investing success, recently described what he calls short-term and long-term debt cycles. In the short-term cycle, central banks create incentives to borrow and spend by keeping rates low. But in the long-term cycle, too much borrowing creates debt burdens, which can create risk-asset bubbles and recessions.
One market that some consider too large -- aside from price -- is the leveraged-loan market, which has proliferated as rates have remained low. Leveraged loans are those made to companies that already have high levels of debt and whose bonds may be trading at a serious discount to par value (or bond value at issuance).
The leveraged loan market, according to the Federal Reserve's most recent Financial Stability Report in 2019, grew 20% year-over-year to $1.1 trillion in 2018. That’s roughly 5% of a U.S. economy expected to produce just over $20 trillion of value in 2020.
Aside from the bonds themselves, the equity of the companies with high debt burdens can often see their valuations remains pressured. Their higher interest rate means their profits are discounted at a higher rate. But the leveraged loan market is undoubtedly contributing to the high debt burden in the U.S.
As for the stock market, it’s safe to say the market isn’t in a bubble, but valuations are high. Since the Fed cut rates, investors are looking for economic growth to reaccelerate in 2020 after 2019’s deceleration. Low rates also reduce the rate at which corporate profits are discounted, boosting valuations.
The average stock in the S&P 500 trades at 19 times next year’s earnings, compared with the 10-year average of 15, making some on Wall Street cautious in the near term. Add in the debt figures and that caution is looking a bit more well-placed.