Like a US recession or China’s post-Covid rebound, a wave of corporate defaults was anticipated this year — but didn’t happen. That doesn’t mean it won’t.
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Credit Where It’s Due
Lots of things were supposed to happen this year, but didn’t. With only weeks to go, neither the recession in the US nor the dramatic post-Covid rebound in China has come to pass. But perhaps the strangest non-event has been the widely anticipated wave of corporate defaults. That doesn’t mean that problems aren’t coming. Oleg Melentyev of Bank of America points out that the bankruptcy of WeWork happened “relatively quietly,” even though it was the largest US company to go bust since the Global Financial Crisis, while the Austrian property group Signa, whose assets include a share in New York’s Chrysler Building, last week became Europe’s biggest post-GFC insolvency. A major repricing of the credit markets to account for those awaited defaults has also failed to happen. But if widespread corporate failures did arrive, they might provide just the catalyst to bring along the much-delayed recession. It’s important to understand why.
Why Should We Expect Defaults?
Financial strength has been declining for a while, a trend that was only briefly interrupted by the attempted cleanup in the wake of the Global Financial Crisis in 2008. The following chart, compiled by Dimos Andronoudis, economist at Fathom Consulting in London, classifies all quoted US companies by their Altman Z-scores — a measure promulgated by the New York University professor Edward Altman to estimate how close they were to bankruptcy. It combines concepts such as account profitability, leverage, liquidity, solvency, and activity ratios. In the last century, more than half of all public companies looked strong and healthy on Altman’s metric. That number has now dropped below 10% for the first time on record:
The Dwindling Band of Financially Strong Companies
On Altman scores, the proportion of healthy firms is the lowest on record
Source: Fathom Consulting
Presenting this differently, we find the number of companies that are imminent candidates for bankruptcy has also been rising consistently, and has reached a new high. The “post-Volcker” era of low interest rates has seen companies grow more and more accustomed to taking risks with their financial health, and getting away with it:
Financial Strength Ain't What It Used To Be
The proportion of US bankruptcy candidates has risen inexorably
Source: Fathom Consulting
Andronoudis stresses that the Altman system may be outdated by now, as intangible assets make up a far greater share of balance sheets and generally do have value. But the idea that credit quality is degrading still stands.
The Threat From Zombies
Another key issue whenever the distortions caused by years of cheap debt are discussed concerns “zombies” — companies that are no longer able to grow or even produce enough profits to cover interest expenses, but can survive because their interest costs are so low. The argument throughout the post-crisis decade was that this would lead to malinvestment, causing companies that were no longer viable to suck in capital that would have been better invested elsewhere.
This chart from Andronoudis defines zombies loosely as companies whose earnings before interest and tax did not cover their interest costs for one year, and also on a stricter basis where this situation needs to have persisted for at least three consecutive years. By this standard, slightly more than a fifth of US companies are zombies:
Rise of the Zombies
20% of US firms have gone 3 years with too little EBIT to cover debt payments
Source: Fathom Consulting
What About the Banks?
The oddest aspect of the credit market’s resilience is that it has come even after the US, and Europe to a lesser extent, suffered a banking crisis. That was driven primarily by the effect of higher yields (and therefore lower bond prices) on banks’ investments. As Societe Generale SA demonstrates here, banks’ unrealized losses remain alarmingly high, while charge-offs on commercial real estate loans, which have grown significantly in the years since the GFC, have only just started to pick up:
The Fed’s survey of senior lending officers’ standards has shown a tightening this year that would normally point directly to a recession. According to Bank of America’s credit team, this survey was in the 90th percentile earlier this year, meaning it had only been tighter 10% of the time. Spreads judged the same way only reached the 75th percentile, staying historically just on the right side of a threshold beyond which defaults can rise sharply. Why don’t the banking sector’s problems matter more? Part of it is that markets have more or less finished supplanting banks — they only account for 15% of all US corporate credit now, according to BofA. And part of it is that the desperation measures launched last March to tide the banks through have worked so far.
Where Does the Problem Lie?
It’s well known that the equity market is increasingly polarized and concentrated, with a few mega-cap companies dominating stock indexes. Credit contributes to this. In this chart from Bank of America, which gauges balance street strength with the simple measure of the cover they have to pay interest charges, we discover that the biggest 150 companies have barely ever been stronger on this metric. Smaller companies are dramatically weaker, and have seen a significant weakening over the last two years:
The Magnificent Seven big tech stocks don’t need to worry about default; a large swath of smaller companies has much more reason to be concerned. As a share of market capitalization, this means that some of the charts so far rather overstate the risk from credit. As a share of employment, the mass of severely indebted smaller companies could do serious damage. There is also a longer-term problem. Even if markets can deal with a wave of small-cap defaults, this would result in a much more concentrated economy. To quote Androudis of Fathom: “The success of the US economy has been because it allows competition. If they leave the US corporate sector to be just a few magnificent companies, then that could harm innovation in the longer term.”
Locking in Low Rates
Arguably the single biggest factor helping to avert bankruptcies to date has been the success of corporate treasurers in negotiating long-term debt when they had the chance during the protracted low interest rates that followed the pandemic. But even a relatively generous high-yield bond is still not going to extend that long, and the average length of time left on junk bonds has dropped precipitously over the last two years as companies have balked at issuing new debt at much higher rates. The following chart, from Jim Reid of Deutsche Bank AG, illustrates the average length of high-yield bonds in circulation in the US and Europe going back to 2002. On both sides of the Atlantic, high-yield borrowers have never had less time to play with:
Are Spreads Adjusting as They Should?
There is also the issue pointed out by Bank of America. Assuming — as seems ever more likely — that the Fed’s last hike was the final one for this cycle, then you would expect two-year yields to start falling, and until recently they’ve failed to do so. Meanwhile, the spread of junk bonds over Treasuries should rise after the last hike — and in recent weeks it’s actually tightened:
Like the calm way the market responded to the WeWork and Signa bankruptcies, this is mighty strange. Melentyev, BofA’s head of US high-yield strategy, admits: “Spreads of 400 basis points are very, very tight. They kind of make no sense to me.” He still has very little doubt that they will widen, and in the process quite possibly overshoot to create an interesting entry point next year. The question is how much they’ll widen, and how much damage defaults will do by the time the credit market adjusts its prices.
Another JOLT for the Markets
If you can’t stand the suspense waiting for Friday’s US jobs report, Tuesday brought a great cue on the state of the labor market. US vacancies as measured in the Job Openings and Labor Turnover Survey, or JOLTS, dropped in October to their lowest level since early 2021.
The fresh data highlight that the American labor market — arguably the biggest headache for the Federal Reserve — is indeed cooling even as the overall unemployment rate remains low. Available positions decreased to 8.7 million from a downwardly revised 9.4 million in the prior month. That was below all estimates in Bloomberg’s survey of economists. Further, the decline was broad-based across sectors. The crucial ratio of openings to unemployed workers dropped almost back to its pre-pandemic level. The pressure on employers to offer higher wages to attract recruits has been much reduced:
US Job Openings Slid in October
Vacancies fell to their lowest level since 2021
Source: Bureau of Labor Statistics
“This matters because it adds to other small cracks in the US labor data,” said Don Rissmiller of Strategas, citing examples like surveys reporting that jobs are becoming harder to get, continuing rising jobless claims, a declining workweek, and falling temporary employment, all as unemployment and under-employment are ticking higher. “US real GDP is growing, but we must still digest the lagged effects of policy tightening.”
While yes, policymakers would like to see the labor market cool, they’d prefer to see that happen through lower demand for workers rather than employers slashing jobs. So far, as colleagues wrote, that’s largely been working. Vacancies have retreated from last year’s peak of 12 million while unemployment (and layoffs) stayed historically low.The so-called quits rate, which measures voluntary job-leavers as a share of total employment, held for a fourth month at the lowest level since early 2021. All of this is wholly in line with the “best-case” scenarios now widely canvassed of an “immaculate disinflation” or “soft landing” — which broadly mean that inflation and rates come down without a recession to push them. Yields across the board dropped Tuesday, with the 10-year yield dropping below 4.2% for the first time since August:
Jolted Lower After JOLTS
10-year yields falls to its lowest level in three months
They received an assist, or perhaps another jolt, from the usually hawkish Isabel Schnabel of the European Central Bank, whose comment that rate hikes were “rather unlikely” helped propel German bund yields to their lowest since May:
Schnabel Speaks, Bunds Respond
Dovish ECB comments left the 10-year bund yield its lowest since May
Can things really be this good? “One of the most surprising developments over the Fed’s hiking cycle has been the steady downward trend in job openings from its recent peak, with no drastic increase in the unemployment rate,” Barclays PLC strategist Colin Johanson wrote. “This suggests a relatively painless easing of excess demand pressures in the labor market, with little cost of reducing job openings in terms of higher unemployment.”
To Olivia Cross, North America economist at Capital Economics, the recent rises in the unemployment rate “suggest that the labor market is starting to move along the Beveridge curve [Points of Return note: The curve maps vacancy rates against unemployment rates, and posits that the two should move in line with each other], more in line with a typical business cycle, rather than falling towards the pre-pandemic curve as skills mismatches resolve themselves.” As shown by this chart which Points of Return has featured before from Peter Berezin of BCA Research, for the last few years the Beveridge “curve” has been more of a “spiral”:
A normalizing labor market is central to the growing belief that the Fed could start cutting as early as the first quarter of next year. Here’s what Stuart Paul of Bloomberg Economics has to say:
The softening of the labor market is becoming increasingly turbulent. The downside surprise in October job openings, paired with the increase in unemployment during the month and the rise in continuing jobless claims, set the stage for wage growth to slow.
It also potentially sets the stage for a recession, and therein lies the conundrum. If the Fed were to cut aggressively, it would likely be because the economy is “hitting a wall,” said Raphael Thuin, head of capital markets strategies at Tikehau Capital. “And this is especially because the Fed still has doubts about inflation being transitory. The Fed kept saying it is willing to be patient.”
Hopes for easing rely in part on speculation that political pressures will force the Fed into cutting. Swaps contracts slightly increased the degree of easing they foresee by the end of next year, with the effective fed funds rate anticipated to fall to about 4.06% from 5.33% currently. The contracts also imply a 50% chance of a rate cut as early as next March:
Fed Cut Outlook 2024
Markets are pricing in four to five Fed rate cuts next year
To Peter van Dooijeweert, head of defensive and tactical alpha at Man Group, a Fed rate cut is more than likely going to be a response to something bad in the economy. “I don’t see how, if the economy’s strong and inflation is kind of doing well, why the Fed will suddenly cut rates,” he said. “It wouldn’t make sense. Why bother?” In the event of a “modest soft landing,” he doesn’t see the Fed cutting much. Many disagree. Now, for the next big moment of truth on payrolls Friday. That will be much more meaningful for the landing path.