Debt Warning: The Zombies Are Coming
The expression, “Don’t fight the Fed,” has been taken to the next level during the pandemic—and for good reason. The Federal Reserve (Fed), along with Congress, is trying to keep the economy in suspended animation while the implications of the shutdown become increasingly evident. But the costs of reopening the economy are a major question mark. To be determined is whether it will soon be business as usual or a whole new environment. What we do know is that rising debt could leave the economy stuck in an unrelenting negative feedback loop, one marked by extended bankruptcy risk and increasing numbers of unprofitable, zombie-like companies.
Unconcerned by that prospect, for now, are the surging equity markets, which seem to be saying, “Risk? What risk?” S&P 500 Index returns since the trough suggest that the U.S. market is dislocated from global realities—or perhaps more telling, that Fed liquidity and support is really all that matters. But that doesn’t feel sustainable with so much debt accruing throughout the economy.
Saving the Economy Means Accepting New Risks
One of the most significant actions that the Fed took was backstopping riskier assets. The Fed’s corporate debt purchases helped defrost debt markets that froze in late February. This enabled companies to raise new debt to meet their liquidity needs. Even businesses unable to operate during the quarantine were able to raise money at favorable rates. On May 27, the investment-grade corporate debt market reached an impressive milestone: $1 trillion in debt sales year-to-date. In a more normal year, such as 2019, the market doesn’t hit that level until November.1
If the Fed stood on the sidelines, the current economic situation would be substantially worse amid a massive wave of defaults. A run on the corporate bond market would have exacerbated an already deep recession. The Fed’s quick actions saved plenty of businesses while encouraging investors to take more risk. As discussed in our recent piece on monetary policy dominating the last decade, just the expectation of continued Fed support is sufficient to help restore market confidence.
However, corporate America is not out of the woods. The current situation can be likened to being in the eye of a hurricane. Repeated Fed and Congress promises to provide more assistance are keeping the storm at bay while the medical community, hopefully, works to develop and distribute a vaccine.
The Weight of Debt and the Negative Feedback Loop
In the early days of the crisis, the Fed, Treasury and Congress worked well together to plug holes in the economy, but we are starting to see discrepancies in their views about future government spending. Treasury Secretary Steve Mnuchin argues for a wait-and-see approach. Fed Chairman Jerome Powell advocates for more federal aid to stave off longer-term damage from waves of bankruptcies and high unemployment.2
These differences of opinion reflect how the Treasury still expects a quick bounce back to normal that follows a V-shaped recovery pattern. Conversely, the Fed expects unemployment to peak around 20% with unemployment remaining in excess of 10% through the end of 2020.3 In line with this view, the Fed is in the process of setting up a Main Street lending program to assist small- and mid-sized companies with four-year loans. The Main Street program is one of nine emergency lending programs that the Fed has announced. The goal is to avoid some of the negative feedback loop that could detract from the economic recovery.4
We suspect companies will stumble out of this crisis with higher debt burdens. While corporate America entered the COVID crisis highly levered already, the Fed’s support only adds to the tab albeit at low borrowing costs. The increase in debt creates new risks as the economy reopens. Businesses are reopening into a weaker macroeconomic environment, one in which consumption patterns are anything but certain. To make matters worse, there is the risk that cost-cutting creates a solid negative feedback loop that dampens consumer demand and lengthens the recovery.5
Just one prong of the negative feedback loop can have major negative implications. As illustrated with Europe’s struggle to regain its footing, despite government subsidies that prevented mass unemployment, changing consumer trends and the increased costs of doing business are likely to have a longer lasting and more serious impact.6 When we add the U.S.’s elevated unemployment rate into the equation, the situation here looks bleak.
The restaurant industry paints the picture. Restaurants face the tricky combination of higher expenditures to protect customers and staff and lower revenue. Half of the 30 states that allowed restaurants to reopen limited capacity to 25–50% for social distancing. But just because restaurants may be reopening, does not mean that customers will return. A recent survey of 2,500 U.S. consumers found that three-quarters of respondents planned to avoid restaurants or dine out less frequently.7
Restaurants are just one example, but their case reflects poorly on the argument for a quick rebound in economic activity. Reservations on OpenTable are starting to rise, particularly within states that reopened first. However, those increases are from very low levels.8 As a consumer-driven economy, the U.S. needs consumer spending to pick up significantly in the next few months, or else the economy’s likely to move from the relative calm in the eye of the hurricane back into the wrath of the storm.
Delayed Bankruptcy Risk
Some segments of the economy will take years to recover, if at all. Monetary and fiscal policy prevented a massive wave of corporate failures, but the U.S. is on track to have its highest number of bankruptcies since 2009. In May, 27 companies with in excess of $50 million in liabilities filed for bankruptcy. This brings the 2020 total to 98 bankruptcies, approximately double the number during the first five months of most years since the Global Financial Crisis (GFC).9
According to credit rating agency Moody’s, the current crisis is more severe than the GFC and the coming wave of bankruptcies is likely to be worse. Despite this, there are fundamental differences between the current situation and the GFC. Capital markets remain strong and many companies can access capital from the government or the market. However, the viability of many businesses is in jeopardy. It’s this disruption that continues to weaken the underlying economy.10
According to Edward Altman, professor of finance, emeritus at New York University’s Stern Business School, roughly 8% of speculative debt is likely to default within the next 12 months and 20% over the next two years. The segment most at risk is a large and growing pool of assets. Two-thirds of non-financial corporate bonds in the U.S. are rated junk or BBB, one level above junk. In April, Goldman Sachs predicted that more than $550 billion in investment-grade bonds will drop to junk status by October. This would add around 40% to the speculative debt market.11
COVID uncertainties are disrupting businesses, but, ironically, they’re also potentially saving distressed borrowers from liquidation. Accurately valuing businesses with no clear cashflows or viability in the current environment is a challenge. However, with the potential for a vaccine, few lenders want to force liquidation because delaying action could result in a better outcome for creditors. As a result, many firms may be saved by restructuring.12
Some of these firms will be able to adapt to the changing market conditions, but there will also be those that remain zombies. Unable to regain profitability, these firms will be a drain as they continue to use resources that could be better used elsewhere.
Consumer Debt No Exception
An increasing number of consumers cannot afford to pay their mortgages, auto loans and credit cards. Bank forbearance programs for millions of Americans help as a short-term solution. But missed payments are deferred, not forgiven. Monthly costs will be higher for many consumers when they are able to start paying again. Unless employment bounces back soon, these programs will need to be extended.
For lenders, this is a challenging tradeoff. Being more accommodative with borrowers could pay off over the long term as the economy recovers; however, lenders can only accommodate these deferrals for so long. At some point these potential bad loans need to factor into their delinquency rates.13
During the first quarter, banks put aside large provisions to deal with an increase in bad loans. Second and third-quarter bank earnings will provide more clarity on how large these losses ended up being. This will provide some insight into the recovery of the underlying economy. The rate of consumers entering forbearance programs is starting to slow and continuing jobless claims may have peaked at almost 25 million, but high levels of unemployment are likely to detract from the recovery for an extended period.
Whatever It Takes Can’t Last Forever
The current Fed-fueled calm is much-appreciated relief; however, greater risk-taking and increased debt levels raise the potential for an even deeper downturn.14 Corporate defaults are likely to continue to rise. After the initial rush for liquidity, corporate borrowing is expected to be substantially lower for the remainder of the year.15 Less issuance in the primary debt market could decrease liquidity, the effect of which would be compounded if there is an increase in recent debt issuers filing for bankruptcy protection. The Fed’s emergency actions were essential, but there will come a time when the economy and market need to come off life support. Figuring out how to remove this support without causing distress within corporate lending markets and throughout the real economy will be a major challenge—one that is likely to drag on.