The Good, The Bad, The Ugly (Vis-à-Vis Corporate Balance Sheets, That Is)

When it comes to predicting the next recession (and by the way, you don’t have to be a “permabear” or a doomsayer to know that the cycle will eventually turn – cycles always turn, that’s why they’re “cycles”) choosing the “right” indicator is something of a parlor game for economists, analysts and pundits.

Everyone has their favorite go-to warning sign and they range from the old standbys (e.g., the yield curve) to sometimes entirely esoteric indicators that purportedly backtest well. If you’re a yield curve enthusiast, it’s just a matter of time:

As Credit Suisse’s James Sweeney writes in a note dated Monday, two things you shouldn’t do if you’re interested in forecasting the next recession are: “1) Count the months since the last recession, 2) Observe postwar recessions and write down what patterns emerge just prior to most recessions”.

It’s not, Sweeney says, that counting months and looking at historical precedent is entirely “worthless.” Here’s a great excerpt:

It’s not that these activities are worthless. They have been done so often that the stylized facts that emerge have become platitudes, some of which are surely still relevant.

The problem, rather, is things seem to have changed.

For one thing, calling the next downturn is made immeasurably more complicated thanks to the myriad distortions created by QE, ZIRP and NIRP. In other words, it’s different this time because the policy response that’s characterized the post-crisis environment is unprecedented on all manner of levels.

And while there’s no question that ultra-accommodative policy has prolonged the cycle, Credit Suisse reminds you (in the same note mentioned above) that expansions have been lengthening since in the Great Moderation began, or, to quote Sweeney again, “things seem to work differently after 1982.”

But while economic volatility may have declined on average in this era, the busts have seemingly gotten more dramatic, a reflection of the spiral dynamic described here.

Sweeney notes that while “the economy is simply more stable than it was before 1982”, when the “big ones” (so to speak) come along, they are generally the product of forced deleveraging – and on a massive scale. To wit:

This era has also seen rapid secular debt growth, an increase in market based financial intermediation, high derivatives use, and large capital flows. The era’s two biggest recessions — 2008 and 1991 — involved deleveraging, credit crises, and messy bankruptcies of financial and non-financial firms. In our view, the causal relationship between those balance sheet problems and recessions runs both ways, with those recessions intensifying when balance sheet dynamics weakened by a slowdown started to constrain behavior which then worsened activity further.

So where are we now on that score? Well, there’s good news and there’s bad news on that and then there’s an ugly scenario that could start tipping dominos.

The good news is that while US non-financial corporate debt is sitting an all-time high, the gross (and “gross” can be taken both figuratively and literally there) figure is mitigated by the following factors (from Credit Suisse):

Net debt is stagnant and near its thirty-year average

Firms have also lengthened the typical maturity of their debt. The share of short-term debt, which includes commercial paper and non-mortgage corporate loans, is now 28%, nearly an historical low

The corporate sector’s liquid assets are sufficient to cover 51% of short term liabilities, an historical high.

The bank goes on to note the obvious, which is that the extension of maturity profiles means the effects of the post-crisis monetary policy regime will linger long after those policies are unwound (assuming they don’t end up being semi-permanent, which they very well might). Sweeney also reminds you that interest coverage ratios are generally healthy.

Ok, so what’s the bad news? You should already be able to come up with at least a couple of plausible answers to that question. For one thing, more than a third of non-fin corporate debt is floating rate.

And then there’s this:

As much as 85% of non-financial corporate loans have floating rates tied to either LIBOR or the prime rate .When three-month LIBOR rose above 100bps in early 2017, most of the interest floors were breached so incremental rate increases now impact the interest rate costs of most corporate floating rate borrowers.

Oops.

More importantly, don’t forget about the rise of cov-lite loans. You’ve probably read something about this lately. Basically, three-quarters (or more) of the U.S. leveraged loan market is covenant-lite now, and although Credit Suisse reminds you that “default rates for full-covenant deals are actually higher than covenant-lite loans in 2013 to 2016”, the risks here are obvious in the event broad market conditions start to deteriorate in a hurry.

Additionally, CLOs have made a comeback and are now on fire thanks to the “protection” they promise in a rising rates environment. The repeal of risk-retention (celebrated by many) is probably a disaster waiting to happen. In short, a lot can go wrong here (see the cov-lite discussion above) and as Sweeney rather dryly notes, “at some point rising interest costs for issuers could lead to a correlated rise in defaults.”

Overall though, Credit Suisse’s take is reasonably benign. There’s a section at the end of the note called “dangerous dynamics” in which the bank reminds you that while everyone is worried about the flattening curve, vicious bear steepening is the real disaster scenario, something Deutsche Bank’s Aleksandar Kocic has been over time and again over the past year.

Here’s what Sweeney says could turn the situation ugly:

Trouble emerges when rising cash or long-term rates occur abruptly and coincide with widening credit spreads. Inflation fears could cause the market to price in a much more hawkish Fed. Supply-side developments (an end to central bank purchases, US fiscal needs) could lead to a sharp increase in term premiums in the government bond market. If rising rates occurred alongside strong growth, credit markets should not be severely disrupted. But if growth is soft, credit spreads are likely to widen, and the flow of credit is likely to fall sharply, quickly dampening the outlook for growth.

So there you go, the long and the short of it. Draw your own conclusions.