With the economic downturn caused by the COVID-19 pandemic, corporate debt piles have grown fatter than ever. The pandemic caused corporate debt to increase $1 trillion last year to more than $11 trillion today – the highest it has ever been. It has nearly doubled since the last financial crisis.

The only reason companies can afford this record debt is because of the Fed’s near-zero interest rate policy over the past decade. But debt has grown so large now that even with near-zero interest rates, many companies are choking on their debt.

Companies that don’t earn enough profits to pay for their interest costs are called “zombies.” They have no hope of ever paying off their debt. Today, one out of every four public companies is considered a “zombie.“

Corporate credit quality is at an all-time low.

The percentage of corporate borrowers who have credit ratings below investment grade – in other words, “‘junk” credit – is now at an all-time high of 58%. Said another way, nearly six out of every 10 borrowers in the U.S. have dubious credit ratings. That’s up from 43% in 2004.

Here’s why that’s important. The default rate increases dramatically the further you go down the credit ladder. These are the borrowers who are much more likely to default.

To put it simply, corporate debt has never been larger or more burdensome than it is right now.

The truth is many companies have only been able to keep paying their bills during the pandemic by borrowing. But you can’t borrow yourself out of a crisis.

Eventually, all of this record-setting debt must be repaid or refinanced.

For many companies, the shift to a remote and digital economy means sales and profits will never recover to pre-pandemic levels. And with lower sales and profits for many companies, the prospect of repaying or refinancing this debt is looking less likely with every passing day.

That leads me to a simple conclusion; Much of this debt won’t ever be repaid.

The only way it will be cleared off the books is through bankruptcy. We’re certain to see a massive wave of bankruptcies in the coming months and years.

Last year, 146 U.S. companies defaulted on their debt, according to credit-ratings agency Standard & Poor’s (“S&P”). That’s the highest number of defaults since 195 companies defaulted in 2009 during the last financial crisis.

In a normal credit cycle bottom, all of the bad debt from the excesses of the cycle gets wiped away, leaving corporations with less leverage. That’s what we saw during the last financial crisis. But that didn’t happen this time.

Excessive debt balances can only continue to rise for so long. Eventually – and in most cases, suddenly – companies will collapse. We are approaching a new credit crisis where many companies will fail and bond prices will plummet.

Sequence of Return Risk

It makes a great deal of difference when you start your retirement. If you start at a time of high valuations (like now) the chance your money will run out before 30 years is also quite high. In fact, in the chart below, if you start at the top 25% of valuation quartiles you would run out of money in an average of 21.8 years. Your money only lasts 30 years 47% of the time. Not exactly good odds. Starting at low valuations? Well, the force is with you.

 

 

Most Americans are counting a perennial Bull market to fund their retirement.  We aren’t.  The two-sided strategies should do well in a flat market filled with trends up and trends down.

 

Market Data

 

  • Bonds yields plunge, the US Dollar surges and the reflation trade unravels.
  • The 3-month increase in expected S&P 500 earnings per share (EPS) for Q2 was the highest in years.
  • Starting last year, global investors held more US equities than US investors owned abroad.
  • Information technology, the largest sector in the S&P 500, has a relatively low effective tax rate of just under 17%.
  • Market breadth is dropping, meaning that the number of stocks advancing to support this uptrend is starting to wane. If the indexes were to keep rising, you would expect the number of individual stocks in uptrends within them to keep increasing, too. But that’s NOT what is happening today.

 

 

  • Treasury yields tumbled, and the curve flattened. Bond yields around the world followed (see the rates section). It wasn’t entirely clear just how much of the Treasury rally and the downshift in risk sentiment on Tuesday was due to the disappointing ISM report.

 

 

 

  • There has been a flood of money into equity mutual funds and ETFs over the past 6 months, the most ever for the first half of a year. As a percentage of stocks’ market cap, the inflows aren’t nearly as extreme but still high enough to show poor forward returns.
  • The rally in recent weeks has been driven by mega-cap companies – boosted by falling bond yields.
  • Smaller firms, however, are not participating in the rally. The Russell 2000 has underperformed the S&P 500 by some 6% over the past month.
  • The top ten firms trade at a massive premium to the rest of the S&P 500.
  • Growth vs. value has been whipped around this year as bond yields pull back.

 

US Economy

 

  • Home prices are pushing into bubble territory again.

 

 

 

  • The ISM Services PMI came off the highs, surprising to the downside. To be sure, US service sector activity continued to expand at a healthy pace in June, but growth was slower than in May.
  • The employment index dipped into contraction territory (PMI < 50).
  • Prices continued to climb, but a touch slower.
  • Service firms, particularly retailers, are struggling to fill orders amid supply bottlenecks (slow deliveries) and extraordinarily tight inventories.
  • Given the urgent demand for labor in many areas, more workers should be coming off unemployment.
  • Job openings in May were roughly unchanged from the month prior.
  • Labor shortages remained acute.
  • There is now roughly one job opening per one unemployed American.
  • Many small businesses continue to struggle.
  • Mall visits haven’t fully recovered.
  • The Evercore ISI trucking sales index hit the highest level in decades.
  • US growth is set to outperform other advanced economies over the next 18 months.
  • Long-term inflation expectations have been moderating.

 

COVID Update

 

 

 

 

Thought of the Week

 

“Being educated is the difference between wanting to help others and knowing how to help others.” – Unknown

 

2 Pictures of the Week

 

 

 

All content is the opinion of Brian J. Decker