Nonfinancial Corporations Overleverage – A Bigger Brick in the Wall of Worries

Photo Credit: takomabibelot

I have my list of concerns for the economy and the markets:

  1. Unexpected Global Macroeconomic Surprises, including more from China
  2. Student Loans, Agricultural Loans, Auto Loans — too much
  3. Exchange Traded Products — the tail is wagging the dog in some places, and ETPs are very liquid, but at a cost of reducing liquidity to the rest of the market
  4. Low risk margins — valuations for equity and debt are high-ish
  5. Demographics — mostly negative as populations across the globe age
  6. Wages in the “developed world” are getting pushed to the levels of the “developing world,” largely due to the influence of information technology. Also, technology is temporarily displacing people from current careers.

But now I have one more:

7) Nonfinancial corporations, once the best part of the debt markets, are beginning to get overlevered.

This is worth watching. It seems like there isn’t that much advantage to corporate borrowing now — the arbitrage of borrowing to buy back stock seems thin, as does borrowing to buy up competitors. That doesn’t mean it is not being done — people imitate the recent past as a useful shortcut to avoid thinking. Momentum carries markets beyond equilibrium as a result.

If the Federal Reserve stimulates by duping getting economic actors to accelerate current growth by taking on more debt, it has worked here. Now where is leverage low? Across the board, debt levels aren’t far from where they were in 2008:

Nonfinancial corporations

Nonfinancial corporations

As such, I’m not sure where we go from here, but I would suggest the following:

  • Start lightening up on bonds and stocks that would concern you if it were difficult to get financing. How well would they do if they had to self-finance for three years?
  • With so much debt, monetary policy should remain ineffective. Don’t expect them to move soon or aggressively.
  • Fiscal policy will remain riven by disagreements, and hamstrung by rising entitlement spending.
  • Long Treasuries don’t look bad with inflation so low.
  • Leave a little liquidity on the side in case of a negative surprise. When everyone else has high debt levels, it is time to reduce leverage.

Better safe than sorry. This isn’t saying that the equity markets can’t go higher from here, that corporate issuance can’t grow, or that corporate spreads can’t tighten. This is saying that in 2004-2006, a lot of the troubles that were going to come were already baked into the cake. Consider your current positions carefully, and develop your plan for your future portfolio defense.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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