Debt Level Rising
Dec. 13, 2018 Commentary

Debt Levels Rising

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Our economic outlook theme for 2018 has been Rounding Third and Heading Home. The theme is meant to create the vision in your mind’s eye of a maturing economic ending. Evidence of a mature economic environment mounts not only in the United States, but also overseas. While we suspect the U.S. economic environment, while mature, should stay out of recession for 2019. We continue to believe it will experience gross domestic product (GDP) growth of 2 percent during the year, down from growth of 3 percent for 2018.

If the U.S. economy continues to show growth next year the current expansion will go down in the history books as our nation’s longest-lived economic expansion, surpassing the duration of the expansion from 1991-2000. Recessions occur for reasons and don’t occur simply because the economy is “due” to experience a contraction. The reasons for recessions vary, but they happen when a major economic factor is out-of-balance. The economy has too much of something, or too little of something else.

That being said, recessions tend to be accompanied by financial excesses, as debt creation escalates to the point where debt servicing levels are unsustainable.  This is true for all recessions over the last 10 business cycles, except for the economic contractions, which were driven primarily by the rise of OPEC and oil embargo activity. The unsustainability of debt structure is typically intensified by rising interest rates, driven by Federal Reserve policies of attempting to either cool hot growth, or slow building inflationary pressure. The combination of increased debt levels tied in with rising interest rates normally accompanies the end of an economic cycle. High debt levels and rising interest rates act as the tinder which intensifies the risk of an upcoming economic contraction. They normally don’t act as the actual spark which ignites the downturn itself.

Why is this the case? Fundamentally, the extension of credit represents an investor (or banker) being willing to lend money to a customer for spending purposes. Debt is the promise of the customer to service (pay interest) and repay the debt upon maturity. From an economic standpoint, the creation of credit, as represented by debt outstanding, increases economic spending and increases economic liabilities. Looked at from an accounting standpoint, the creation of debt increases the economic income statement and decreases net worth by increasing liabilities. So, the creation of debt tends to increase growth while weakening the national balance sheet.   

There is nothing wrong with this activity, as long as the investment made with the borrowed money can service the outstanding debt. When the ability to properly service the outstanding debt is placed in jeopardy (by rising interest rates or a failed investment), or the debt can’t be repaid, then the borrower is thrown into trouble. As debt levels in the economy rise, the probability of default increases.  Consequently, the extension of credit and the creation of debt by itself isn’t a problem. It’s how the capitalist system works. But when the ability to properly service debt lessens, economic growth struggles and financial risks rise.

Where We Stand

With the background mentioned above, where does global debt structure stand? Of course, the world’s economic system is more levered than any time over the last 10 years, which happens as a business cycle matures. The degree of leverage in comparison to the size of economic output (akin to comparing debt outstanding to income) is high in certain pockets. Let’s look at the more extended examples.

  • U.S. Debt: Currently the outstanding non-financial debt of the U.S. economy represents 248 percent of GDP, up from 242 percent in 2010 as the economy was coming out of recession. Overall debt creation has expanded as compared to overall economic growth. The real story, however, is the composition of that debt structure.
  • Emerging Economy Debt: Emerging economy debt levels as a percent of GDP are currently at 173 percent, lower than the United States. However, those levels have risen from roughly 100 percent of GDP over the last 10 years.
    • The real concern regarding emerging market debt creation is centered on the non-government portions of these less-mature economies. Private debt as a percent of GDP currently is at 149 percent of GDP, as compared to a ratio of around 80 percent 10 years ago. To compound this risk exposure, much of this private debt (businesses and consumers) is denominated in U.S. dollars, which adds significant repayment and servicing risks to this debt structure.
  • China Debt: Above please find a chart, courtesy of Ned Davis Research, which shows emerging economy debt-to-GDP ratios broken down by specific country. Note the most levered country in this chart is China, the world’s second largest economy, with a debt-to-GDP ratio of 210 percent. If we include China’s outstanding government debt in this analysis, we will see that the total debt-to-GDP ratio in China is now more than 250 percent as compared to 150 percent in 2008. Corporate bond defaults in China have reached $10 billion this year, a record high. Due to these and other concerns, borrowing costs for China’s high-yield borrowers of dollar bonds have almost doubled to 11 percent.

Corporate Debt Structure – 2007 Redux?

As stated earlier, recessions are accompanied by rising debt levels. Along with the data mentioned above, it is interesting to note that the corporate loan market (as compared to the corporate bond market) has risen to a total of $1 trillion in debt, per LeveragedLoan.com. According to this survey, 77 percent of these balances are covenant light loans. Covenant light loans are loans made to corporations with limited lender rights attached. They tend to be treated as high-yield loans. 

Many of these loans are packaged by Wall Street and resold to investors. Actual bank lending activities have been well behaved, but some excess may be building in the securitized bank lending arena. Recently in a Barron’s magazine article, when asked what bothersome risks are building within the financial system, Michael O’Neill, Chairman of Citigroup, stated “people talk about the problems of levered lending and the growth of collateralized lending obligations (CLO’s). Gosh, these look like CDO’s”. Of course, CDO’s were part of the financial storm which occurred in 2008-2009.

What All This Means

By themselves, high levels of debt-to-GDP don’t mean the world’s economy is in, or immediately heading towards, recession. Rather, it signals that the current economic cycle is mature. The debt levels mentioned above are reminiscent of previous debt structure levels which have occurred prior to previous economic recessions. As debt levels rise, by definition risk levels rise as negative outcomes are inflamed by the use of debt. 

As mentioned above, debt levels by themselves don’t create recessions. Rising costs of carrying debt and the inability of borrowers to properly service outstanding debt do. Once again, we are looking for global and U.S. economic growth rates to slow in 2019, but we continue to suspect that the United States will stay out of recession in 2019. The yield curve (relationship of two – 10-year Treasury yields) remains positive and the Leading Economic Indicators are positive. The weight of the evidence still suggests a recession is some ways off. But, the risks of a global economic recession are rising as the current cycle matures.

Sources:  

Strategic Economic Decisions – Rising Corporate Debt Levels – Will these Lead to a U.S. Recession?  October 2018
Wall Street Journal 11/24/18
Ned Davis Research 
The Economist Magazine – Schumpeter – China v America - 11/17/2018

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