Yikes, Lofty Corporate Debt Will Hurt Us When Earnings Slip, Moody’s Warns

Record leverage, at 46.6% of GDP, leaves companies vulnerable, says economist Lonski.

Just you wait, trouble is brewing. That’s the warning from Moody’s that today’s sky-high corporate debt will bring major problems once earnings finally slide.

The surge in leverage among nonfinancial corporations is worrisome because it raises the risks of something going wrong once the earnings party is over, according to John Lonski, chief economist at Moody’s Capital Markets Research, in a research note.

Last year showed a record 46.6% level of this debt as a share of gross domestic product. That’s compared to 41.7% in 1998. Meanwhile, the amount of cash on nonfinancial corporations’ balance sheets has shrunken by 8% as of year-end 2018. So there is less cushion for companies to fall back on.

The danger from the huge debt load “will not become manifest until core profits’ yearlong average shrinks more than 5% from its current zenith,” Lonski wrote in a research note.

Right now, as the first quarter’s earnings reporting season winds up, profits look to be flat. That gives the lie, at least temporarily, to original projections that 2019’s first period would show that iniquitous 5% drop. Of course, the flat reading marks a slowdown from 2017 and 2018’s double-digit quarterly earnings increases. Last year’s final quarter was up a heady 20.5% for the S&P 500.

The latest Blue Chip consensus forecast expects a 4.5% 2019 pre-tax profits growth for all US corporations, and a slightly slower 2.7% expansion in 2020.

Lonski pointed out that the swelling corporate debt “has been skewed toward riskier firms,” which will be especially vulnerable come an economic downturn. For the time being, US high-yield bonds have a below-trend default rate of 2.7%. 

Encouraging this debt binge is the low interest rate environment that has been around since the Great Recession. Lonski quotes Richard Clarida, the Federal Reserve’s vice chairman, blaming demographics as a big reason for the low-rate situation, as well as for a stunted outlook for future earnings increases. The US population is aging rapidly, which will lead to fewer people working and more unproductive retirees spending down their assets.

All in all, rather grim. But at the minimum, things are OK for the moment.

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