The U.S. economy is entering a sharp recession, with the global economy following suit. The conventional wisdom is that the coronavirus outbreak - an event that came out of nowhere and could not possibly have been anticipated - is to blame. While it is obviously true that the outbreak (and even more so, the resultant quarantines and lockdowns) catalyzed the recession, that does not mean it is the only reason for the economic difficulties being experienced right now.
For more than a decade, the U.S. had enjoyed a sustained bull market, the likes of which had never been seen before. Is it any wonder that we have now arrived at a recession that will prune away the dead weight that has accumulated in the economy? I recently came across an interesting note from Morgan Stanley’s (MS, Financial) research department that sparked some thoughts on this point.
The danger of corporate leverage
Mike Wilson, the bank’s chief U.S. equity strategist and chief investment officer, identified an area of the U.S. economy that had become particularly susceptible to the inevitable downturn: corporate credit. He wrote:
“We’ve never seen corporate leverage as high as it is now, and much of this credit has been added because credit markets have rarely been so inviting to issuers. This is a direct result of the financial repression era, orchestrated by central banks post the financial crisis. In short, the abnormally low cost of borrowing has encouraged companies to lever up, and use this financial leverage to drive better earnings growth in what has been a sluggish economic recovery.”
More than a decade of ultra-low interest rates made corporate America (and Europe) very hungry for cheap loans that it felt it could easily pay off. Growth was slow, but that seemed to be OK because interest payments were so small, and there was always the expectation that loans could be refinanced at lower interest rates as central banks continued to lower benchmark rates.
Now that growth is plunging (most U.S. gross demestic product estimates for the second quarter of 2020 range between -8% and -15%, with some forecasting much worse results), it is inevitable that corporate lenders will begin to tighten their standards. Credit spreads - the difference between the yield on government bonds and corporate bonds - have exploded, meaning that lending money to companies is now being viewed as much more risky than before. The Russia-OPEC energy spat has only added fuel to the fire, making it hard for Western policymakers to stop the bleeding.
The result? The fastest bear market in history. This precipitous decline has been exacerbated by a second structural problem identified by Wilson: the shadow banking sector. We shall return to what this means for investors in part two of this series.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor’s Handbook: How to Read a 10-K, Part 2​
- The Value Investor's Handbook: How to Read a 10-K, Part 1
- Howard Marks: The Problem With Forecasters
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