Risking Another Financial Crisis

March 24, 2020


With the United States being Egypt’s second-biggest trade partner and the third-largest direct investor in Egypt, the health of U.S. economy has considerable influence on the Egyptian economy and its growth. As such, reports over the past few months from American think tanks and economists warning of an impending recession should raise red flags in Egypt. “There remains one significant and serious risk to emerging markets: a US recession,” wrote Barry Eichengreen, a former senior policy adviser at the International Monetary Fund, in the Guardian in December 2019.

Such a recession may be accelerated by a potential corporate debt “bubble” given that U.S. firms have been piling on low-interest debt for over a decade. According to an August piece by Ariel Santos-Alborna, a columnist at Seeking Alpha, an online portal for stock investors. “Corporate debt to GDP is at its highest level in recorded history.” At the end of last year, more than 58 percent of investment-grade bonds were rated BBB, only one rank above investment grade, according to Barrons, a publication. “Compared with previous credit cycles, today’s stock of outstanding corporate bonds has lower overall credit quality, higher payback requirements, longer maturities and inferior covenant protection,” according to the Organization for Economic Co-operation and Development (OECD) as reported by Reuters in October.

A meltdown in corporate finances could happen if the U.S. economy suffers a slowdown that results in a downgrade of BBB-rated debt to junk. “A downturn half as severe as the one spurred by the last financial crisis would result in [trillions of dollars in] corporate debt being considered ‘at risk,’ which the IMF (International Monetary Fund) defines as debt from companies whose earnings would not cover the cost of their interest expenses,” noted the Reuters article.

Brewing crisis

To stimulate the economy after the 2008 global economic crisis, the Fed dropped interest rates from 5.25 percent in 2007 to 0.25 percent by the end of 2009. Companies started borrowing more and issuing bonds. “Debt’s been cheap, so why not do it?” said Jim Schaeffer, deputy chief investment officer of Aegon Asset Management, as reported by Fortune in December. As of February, outstanding U.S. corporate debt topped $10 trillion, according to a Business Insider story. That compares with global corporate debt of $13.5 trillion, according to an OECD report in January.

The appetite for loans invariably lowered the quality of newly issued debt. A Reuters story in February noted that in 2010, 20 percent of corporate bonds were not investment grade. By 2019 it was 25 percent, according to a OECD report in February. Experts, however, are more concerned that nearly 60 percent of all issued debt in 2019 was rated BBB compared to nearly 30 percent in 2009.

Meanwhile, U.S. companies saw average profit margins decline throughout 2019. “In the last six months, the condition of U.S. corporate finances has become more worrying,” wrote Gavyn Davies, chairman of Fulcrum Asset Management, to the Financial Times in October. “Profit margins have come under increasing downward pressure because producers’ wage costs have been rising more rapidly than selling prices.”

Deterioration in profit margins caused companies to curtail investments, according to Bastien Drut, senior strategist at CPR Asset Management. Instead, Rite Aid and other companies have used that money to buy back shares, pay dividends, and finance mergers and acquisitions, according to the IMF, as reported by The Financial Times in October. Those tactics are generally used to prop stock prices, according to Santos-Alborna.

Too good to miss

On the demand side, investors have been hunting for higher returns. “The rush into the corporate bond market reflects investors’ ongoing need for yield at a time when interest rates remain at very low levels,” said The Financial Times article. The publication noted that debt investors poured $180 billion in U.S. corporate funds last year.

That rush was mainly bond investors looking to sacrifice a bit of safety for higher yields. That included Treasury bond investors were moving out of      government debt and into corporate debt. By the end of 2019, the premium paid to investors to finance corporate debt instead of secure government debt dropped to 1.09 percent compared to 1.6 percent at the start of the year. “The spread measures the extra yield — or lack thereof — investors demand to compensate for corporate credit risk,” said The Financial Times. Accordingly, a low yield means higher demand.

Meanwhile, those invested in safe corporate debt started migrating to BBB debt, which has higher yields than better quality debt but is still investment grade. According to Bank of America, the U.S. High Yield Total Return Index (BBB-rated bonds) went from 1,233 points to 1,429 from January 2019 to February 2020.

That increase in demand also translated to stocks just below investment-grade. “As buyers bid up prices, most junk bonds had seen their average yields drop in 2019. B-rated junk, for instance, has fallen to 6 percent, from just over 8.45 percent in early January,” wrote Fortune in December 2019, a clear sign demand outstrips supply.

Wobbling economy?

The U.S. economy grew 2.1 percent during the second half of 2019, yet the IHS Markit U.S. Manufacturing PMI is hovering between 53 and 50 points, where the latter benchmark indicates that business is stagnant. Those are the lowest scores for the U.S. economy in more than seven years, according to Trading Economics. “If that trend continues, the remainder of the U.S. economy may struggle to offset the drag from a sluggish manufacturing sector. Even if the U.S. is less dependent on manufacturing than in past decades,” Simon Moore, chief investment officer at Moola, told Forbes in January.

Meanwhile, the New York Fed’s Probability Index, which measures the likelihood of a recession in the following 12 months, shows a 32.9 percent chance of a recession this year. Business Insider says it is the highest level since 2009, noting “the measure has breached the 30 percent threshold before every recession since 1960.”

U.S. economists are quick to note the global economy is overdue for a recession given that one has occurred every decade. “Between 1929 and 2008, the United States had 14 recessions, which is [on average] a recession every 5.6 years,” David Marotta, president of Marotta Wealth Management, told Forbes in January.

Another cause for concern is that as of February 21, yields on U.S. Treasuries maturing in under one year were higher than treasuries maturing from one to three years. Matt Philips, a reporter for the New York Times, explained: “Long-term interest rates are higher because, like any borrower, the government ought to be paying more to borrow for 10 years than for three months. But every once in a while, things get flipped around in the bond market, and short-term interest rates rise above the long term in a sign that investors expect slower economic growth.”

Lastly, ongoing trade disputes with China and other countries putting the U.S. economy in a precarious position. “If you roll this back to a year ago, we were on track to seeing a very strong economy, lower unemployment, wage growth was picking up, particularly at the low end,” Mark Zandi, chief       economist at Moody’s Analytics, told Newsweek in November. “But then we had the trade war. The trade war has done very serious damage to the economy and, in fact, if the president decides to continue to pursue the trade war, recession risks will rise.”

First hit

According to Santos-Alborna, companies with BBB-rated debt would be hurt most as a slowdown in their sales growth rate could cause credit-rating agencies to downgrade their debt into “junk” territory. “So when cash flows decrease in the next recession, [there would be] less net buyers of BBB debt in a flight to safety, and many BBB corporations become downgraded to junk,” he wrote in a blog on Seeking Alpha in December. As a result, share buybacks currently propping up the stock market will come to a “screeching halt and nothing will be left to support current equity prices,” he added.

As sales decrease in a recession, those precarious firms could find themselves unable to repay their debt or issue new debt. “The junk bond market is less than half the size of the BBB market and typically faces a lack of liquidity at the first sign of recession,” said Santos-Alborna. “A nearly illiquid junk bond market cannot absorb a wave of BBB downgrades.” That would raise the likelihood that those companies would resort to selling off assets to pay their liabilities, similar to what Rite Aid did, or file for bankruptcy.

To prevent a financial meltdown of U.S companies, some experts say Washington would be “forced to bail out overleveraged corporations,” said Santos-Alborna. Alternatively, the Fed would have to maintain low interest rates, while stimulating the economy. That would ensure that enough cheap debt flows into those companies and enough profits to pay those debts.

Peter Schiff, CEO of Euro Pacific Capital wrote in an October blog: “This is a giant house of cards just waiting for something to nudge the table and send the whole thing toppling down.”