Danger in the Credit Markets

U.S. corporate debt-to-GDP levels are near all-time highs. What this could mean for your portfolio over the coming quarters

The U.S. stock market has staged a wildly impressive comeback after its 4th quarter implosion … The U.S./China trade talks seem to be nearing a positive conclusion … The Chinese stock market is showing some signs of strength … Europe hasn’t completely fallen off a cliff yet …

Overall, things are pretty good for investors, right?

Perhaps. But there is one very bright, red flag which isn’t getting the attention it deserves. In this Digest, let’s shine some light on it.

As you’ll see, I’m not suggesting this is going to lead to a stock market meltdown tomorrow. However, this issue does have the potential to result in major losses for some stocks later in 2019 and beyond.

Given this, let’s make sure you’re aware of what’s happening so that you can analyze your own portfolio today, perhaps making some necessary adjustments before it’s too late.

At the end of this Digest, I’m even going to give you a free tool to help your analysis.

***Today’s “red flag” began in the wake of the financial crisis

In the quarters following the Global Financial Crisis, many U.S. families went through the painful process of deleveraging and getting back to Economics 101 — basically, learning to live within a budget.

Meanwhile, a great many U.S. businesses went the other direction — they began gorging on cheap debt.

Now, let’s establish a bit of context …

The Federal Funds Rate is the interest rate that banks charge each other when lending Federal Reserve funds overnight. In general, the Federal Reserve uses this “Fed Funds Rate” as a tool to control U.S. economic growth. All of the interest rates that affect you and me — bank interest rates, mortgage rates, car loan rates — in one shape or another, they are all affected by this Fed Funds Rate.

So, if the Fed wanted to, say, help out a sluggish economy, it would look to lower this Fed Funds Rate. By extension, this would lower borrowing costs for people like you and me. And that would make it easier for us to spend money, which would help the economy.

That’s what happened in the wake of the Global Financial Crisis. Beginning in December 2008, the Fed targeted a Funds Rate of 0.25%. Basically zero.

As you can see below, the Fed didn’t raise rates again until December 2015.

So, we basically had seven years of free borrowing. And the corporations began feasting on it …

***During this time, corporations began loading up on cheap debt

In 2007, total corporate debt came in at nearly $4.9 trillion. Through the mid-point of last year, that number had ballooned to $9.1 trillion. That’s an 86% increase.

Today, the ratio of U.S. corporate debt to the U.S. GDP is at 46%. That’s just below its all-time high from a few months back.

But let’s contextualize this level. Here’s a chart from HSBC that puts our current debt level in more perspective.

“So what?” you might ask. “The S&P is up over 250% since 2009. Why do these debt levels matter?”

Well, let’s take the same Fed Funds Rate chart from above. But this time let’s look at what’s happened since 2015 …

Since the low of 0.25%, the Fed Funds target rate has steadily climbed. Today, the target is between 2.25% and 2.5%. That’s about 800% – 900% higher.

What’s the impact of this change in levels?

Well, let’s say you found a great credit card that offered an interest rate that was practically zero. So, you went out and splurged on all sorts of things you wanted. Your personal debt levels rose to all-time highs. But for years you didn’t need to worry because your credit card payments were easy to manage at that near-zero rate.

But what if your credit card company called one day and said it was raising its rate 800%-900%? Might those minimum payments on your record debt suddenly be a little more challenging to pay?

Let’s apply this analogy to the corporate debt market.

Many corporations locked in low rates a decade ago. But $3.5 trillion of debt from high-yield and investment-grade issuers will be coming due in the next three years. That means many of these companies will have to roll over their debts when interest rates are much higher.

Now, you might be wondering “Sure, rates are much higher relative to where they started in 2009, but that was basically 0%. In the grand scheme of things, rates are still low, right? So, this refinancing won’t be a problem.”

That’s the rub.

***One of the best ways to analyze the potential danger is to look at the corporate debt-to-cash ratio

Paying higher debt service costs isn’t a big deal if corporations have tons of extra cash on their balance sheets to pay off those higher costs. Is that the case?

According to a recent CNBC report, excluding the biggest U.S. companies, the corporate debt-to-cash ratio is now higher than it was in the 2008 financial crisis (so less cash relative to debt levels). And the riskier corporate borrowers are more leveraged than ever. From the CNBC report:

The cash-to-debt ratio of speculative-grade borrowers reached a record low of 12 percent in 2017, below the 14 percent level in 2008 — meaning that for every dollar they have in cash, they have $8 of debt.

Financial Times report from Monday echoed this risk:

In the next three years, a third of U.S. triple-B rated bonds will come due — a “wall of maturities” that will test the balance sheets of highly levered companies, predicts Kristina Hooper, chief global market strategist for Invesco, the $888bn-in-assets Atlanta-based fund manager.

“This is a potential crisis that could evolve,” Ms Hooper said. “We could see a situation where companies are not able to cover debt service or, when debt matures, obtain new funding at higher levels, squeezing profit margins.”

***This brings us to stock market values, which are based on earnings that are related to these profit margins

First, let’s be clear — none of the above implies we’re standing on the edge of stock market chaos. That’s not the case.

Instead, over the coming quarters, we’re going to begin seeing a divergence between fundamentally-strong companies and everything else. As this mountain of debt rolls over and companies have to refinance at higher rates, it’s going to put pressure on earnings.

The fundamentally-strong companies that have been growing their revenues are going to be able to absorb these higher debt costs. That’s going to mean that earnings per share remain strong.

But the weaker companies that haven’t been growing — or have even been suffering lower revenues? Well, the higher debt costs could easily make a noticeable dent in earnings per share. And that will likely translate into falling stock prices.

***If you’ve been reading Louis Navellier, you’re already aware that the number of companies with strong earnings is going to be declining in 2019

For any readers unaware, Louis is a true market veteran. As the editor of Growth Investor, he has one of the best track records in the industry. He’s a master at identifying the companies poised for market gains based on the strength of their earnings power.

Here’s how Louis has explained this earnings environment to his subscribers:

Personally, I expect that the S&P 500 will beat analyst expectations and continue to post positive earnings in the first quarter. But investors will still face a huge challenge: Identifying which stocks will sustain strong sales and earnings momentum.

Essentially, the stock market will act like a funnel and divert funds to stocks that will continue to prosper in a decelerating earnings environment.

As to the source of the more challenging earnings environment, Louis has pointed toward multinational stocks that are suffering currency headwinds.

Yet, the source of declining earnings — whether it be currency headwinds in the near-term and/or corporate debt issues in the medium term — isn’t what’s important. What is important is the reality that the “rising tide lifts all ships” market conditions that we’ve enjoyed for many years is disappearing. This means that investors will need to be far more rigorous in their individual stock selections.

***So, how do you measure the strength of the companies that are in your portfolio, and whether they’ll hold up in a challenging market?

It turns out, Louis provides his Growth Investor subscribers a free report called “8 Plunge Protection Steps to Thrive in Market Selloffs.” One of these 8 steps applies equally well to analyzing a company’s fundamental strength. As Louis writes, “And after years of crunching the numbers, I’ve figured out the eight most important variables that help predict a company’s profit potential.”

He points toward sales growth, operating margin growth, earnings growth, earnings momentum, earnings surprises, analyst earnings revisions, cash flow, and return on equity.

Now, let’s be realistic — if you analyzed all these factors for every stock in your portfolio, it could take a long time. But did you know that Louis offers this service — for free? It’s called the “portfolio grader” and it evaluates a company by the metrics I just identified, revealing a composite score.

For instance, here’s a screenshot of the results for Microsoft:

Growth Investor subscribers can even log in to see the specific grades a company receives for each of Louis’ metrics.

Wrapping up, corporate debt levels are troubling. Over the coming 18-24 months, we’re going to see the profits of some companies shrink as they struggle with their debt rollover. Even before then, we’re going to see other companies struggle as the collective earnings environment grows more challenging.

If Louis is right, it’s looking like the easy days are growing numbered. Let’s begin preparing for what’s next.

Have a good evening,

Jeff Remsburg

Article printed from InvestorPlace Media, https://investorplace.com/2019/03/danger-in-the-credit-markets/.

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