As corporate debt rises, so do worries about it triggering the next recession

Published October 5 2018

Corporate debt isn’t the sexiest topic. For nearly all of us, it’s economic Muzak, mere background noise as we tackle more pressing financial matters like paying rent or funding retirement.

Get prepared to hear a whole lot more about it.

By some measures, companies have more debt than at any time in history and not enough cash to weather the next downturn. Some of the folks who follow this stuff are equating it to a scaled-down version of the home mortgage binge we went on from 2003-07. We know how well that ended.

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Depending on who’s talking, the threat ranks somewhere between keep an eye on it and duck and cover. The potential menace could help trigger the next recession or amplify any financial shock, though that’s far from certain.

Sarah House, senior economist at Wells Fargo, cautioned against panic. "Stay tuned" was her recommendation.

Wells Fargo was concerned enough to create a new index to track the health of the corporate sector, one that focuses on debt and how likely companies are to pay it back. Not all of the eight components that make up the index look that bad at the moment.

"But the point is the direction we are moving, and how things are deteriorating," she said Thursday. "We are seeing some imbalances build up which makes the economy more vulnerable to headwinds."

Big companies started loading up on debt after the Great Recession. Ultra-low interest rates meant borrowing was cheap and easy to pay down. It stayed that way for years. The total owed by the country’s non-financial corporations stands at $9.4 trillion, up $3.3 trillion since the recession ended. That’s the most ever, as a share of gross domestic product.

Compare that to, say, the $1.5 trillion we owe in student debt and you get why there’s some anxiety, or as Wells Fargo put it, "a sense of disquiet."

A major contributor: Interest rates have begun to climb and are expected to rise more over the next year or so. While much of the corporate debt is locked in at low rates for years, an increasing slice of it isn’t. It’s subject to those rising short-term rates. That can make it harder for companies to pay back.

These aren’t all small or obscure companies. Campbell Soup, Stanley Black & Decker and General Electric have higher levels of short-term debt, Goldman Sachs reported earlier this year.

Companies with too much debt could have trouble weathering economic adversity, whether it be a stock market crash, spike in oil prices, a 9/11-style attack or something we haven’t thought of yet. Even if they can pay back the debt, the higher interest rates leave less money for companies to invest in themselves. That can put a brake on wage growth and hiring, which in turn affects consumer spending. If spending dries up too much, presto, you have yourself a recession.

Companies are also on shakier ground when it comes to how much they earn compared to how much annual interest they have to pay, though they are in better shape than in the late 1990s before the dot-com bubble gave way to a recession.

Many don’t have much cash on hand, either. S&P Global Ratings follows roughly 2,000 non-financial companies in the United States. Of those, the top 25 alone, including Apple, Microsoft and Google, held half of all the cash.

Removing the top 25 cash holders for the calculations paints a "sobering picture," the financial firm reported earlier this year.

"To be sure, the top 1 percent have more than enough cash to repay their total debt of about $750 billion," the authors concluded. "But for the other 99 percent, credit risk remains."

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Borrowing can be beneficial when it’s used for long-term investments or expansion plans. But some experts worry that too many companies used the money to pay dividends to investors or to buy back their own shares to boost stock prices. That’s a little like taking out a home equity loan to buy a boat instead of using it for a new roof or to add on a second bathroom.

On the plus side: While rising, interest rates still remain low. Also, company assets grew even faster than debt this decade.

In addition, companies in the non-financial sector have far less exposure to the stock market compared to the dot-com years. Back then, stocks accounted for 25 percent of their financial assets, which made them vulnerable when the market collapsed, according to the Wells Fargo report. This year, they hold about 9 percent.

Finally, as a share of GDP, corporate debt remains less than half of what total consumer debt reached before the Great Recession, House noted.

That said, Wells Fargo predicts further deterioration in the corporate sector’s financial health over the next couple of years. The key will be how much.

"I don’t think there is a magic number when this would all fall apart," House said. "But it’s something we will be watching very carefully."

It sounds like we all should.

Contact Graham Brink at [email protected] Follow @GrahamBrink.

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