I wrote this article back in Sept. of 2018 but thought it was worth republishing. I have a feeling that the financial impact from the Coronavirus could be much greater than many people believe. Many corporations are already lowering their forward-looking revenue estimates, and some are saying that their China revenue could drop by as much as 50%. IMO the Coronavirus has the potential to be that trigger or domino leading to a recession or at worst another financial crisis. I want to also say that I am not republishing this to scare anyone. If we panic, then this could become a Self-fulfilling prophecy. My reason is just as food for thought, just to make people aware of one possible side-effect of this outbreak.
It has been about 10 years now since the 2008 financial crisis and we are currently riding the 2nd longest economic expansion on record. Most places you look things look very good, the US stock markets are near all time highs. The S&P 500 is up over 300% since bottoming early in 2009 and nearly double what it was at the peak in 2007. The unemployment rate is sitting at just under 4% near historic lows, the improving jobs market has been pulling more people back into the labor force and even with all the economic momentum inflation still seems to be under control. The US GDP for the second quarter topped 4% which is the highest growth rate since the third quarter of 2014 and US corporate profits are at an all time high. Personally, I see help wanted signs almost everywhere I go and have read numerous articles about a labor shortage here in the US so to me all of this points to a very bright future.
But hold on! Are there dangers to our economy and financial system lurking below the surface? Could there be a domino waiting to fall which could trigger a chain of events leading us into another economic meltdown? I have already listed some of the positive indicators which point to further prosperity, so now let’s look at the possible dominos out there that could possibly derail the US or even the global economy. So first let’s look at the very first thing that I wrote, we are currently in the second longest economic expansion on record, now does that mean that it is going to end tomorrow or next week? Of course not, it could end up becoming the longest on record, but chances are it is closer to the end than the beginning. Economies move in cycles referred to as the economic cycle or business cycle. These cycles are identified as having four distinct phases, expansion, peak, contraction (or recession) and the trough.
We can see by economic indicators that the economy has been expanding for quite some time, so we are obviously in the expansion phase and I would argue that we are getting close to the peak. I am not saying the expansion will end tomorrow, but it could be only a matter of months before it does, and we then transition into another recession.
So, I think we can all agree that sooner or later the US economy will eventually transition into another recession. But that fact alone will not be enough to trigger a financial crisis, so what could be the domino that could trigger a crisis? Besides the danger from a black swan event, in my opinion the biggest threat to our financial system right now is debt. More specifically, corporate debt, government debt is also out of control in my opinion but for this article I will be concentrating on Corporate debt. Currently by many analyst estimations the corporate bond market is now in a bubble, and what is the most likely cause of this bubble? Ultra-low interest rates which are a result of actions by the federal reserve to try and stimulate the US economy after the great recession. A recent report by S&P Global found that the debt held by US corporations has reached a record $6.3 trillion which is higher than it was in 2007. As you can see by the chart below corporate debt to GDP is also once again reaching extreme levels.
This second chart shows another problem, a great deal of that corporate debt is going to be maturing over the next few years. It is true that U.S. corporations have amassed a record 2.1 trillion in cash to help service their debt but most of that cash is held by a few giant companies. In my opinion the real issue here is that interest rates are on the rise making it more expensive for these corporations to not only service this debt but also more expensive to roll this debt forward. According to Wells Fargo Securities corporations will need to refinance about $4 trillion worth of bonds over the next five years which is about two-thirds of all their outstanding debt. With interest rates rising these corporations are going to have to spend enormous amounts of money just to service this debt. Now enter a recession into this mix, so now you have corporations dealing with servicing an enormous amount of debt and then due to a recession their cash flow and profits start to shrink. It is not too hard to imagine that this could push the balance sheets of quite a few corporations to the breaking point. Now one way the corporations could deal with this would be to shrink, layoff employees, reduce inventory, stop investing, sell assets, but if this happens on a large enough scale the only thing it will accomplish is to further deepen the recession, so this then become a vicious circle. Another issue is the size of the financial markets, just prior to the 2008 financial crisis the global financial markets were many times the size of the global economy. They had tripled in size over the prior three decades until they were 347 percent of the global GDP, today they are even larger having grown to 360 percent of the global GDP, which is a record. In my opinion the reason for much of this growth is due to actions by central banks around the world following the financial crisis. In an effort to help the recovery world central banks have massively expanded their balance sheets with much of this newly printed money ending up in the financial markets. Many corporations have also been using money from debt to buy back their own shares thus boosting their stock prices. There is expected to be over $1 trillion worth of share buybacks this year after the passing of the tax reform bill. So, in addition to the bond or debt bubble, in my opinion we also have a bubble in the financial markets, I don’t think you need to be a rocket scientist to see that this is a real problem. I have mainly focused on issues here at home but there are also other “dominoes” out there in the rest of the world that could just as easily trigger a global crisis, number one on that list has to be China’s debt bubble. In my opinion it will only take one domino to fall starting a chain of events that could spiral us into another financial crisis.
So, I am not writing this to try and scare anyone. I believe we all need to be aware that no matter how great things seem right now economically, there are issues with our corporate and financial systems that could change things very fast with the right trigger.
I appreciate you taking the time to read this, I hope you stay healthy and safe.
Donald Hancock