Is Corporate Debt About to Rear Its Ugly Head?

Executive Summary

As we have written in previous reports, a number of financial metrics suggest that the financial health of the non-financial corporate (NFC) sector has deteriorated over the past few years. Although we may not necessarily be on the cusp of a corporate debt-induced downturn in the U.S. economy, the NFC sector is more financially fragile today than it was a few years ago. If a recession were to occur, non-financial corporate businesses could cut payrolls in an effort to improve profitability. The debt in the NFC sector may not be the catalyst of the next downturn, at least not in the foreseeable future, but any recession that occurs in the near term could be exacerbated by the build-up of non-financial corporate debt over the past decade.

Financial Health of the NFC Sector Continues to Deteriorate

In a series of reports over the past year, we have discussed our concerns about the rising amount of debt among non-financial corporations. 1 We were particularly concerned last autumn when the Federal Reserve was in the midst of a tightening cycle. In our view, rising leverage in the NFC sector in conjunction with monetary tightening could have potentially been a catalyst for the next economic downturn. A year later, the Fed has eased policy rather than continue to tighten, and the immediacy of increasing leverage among non-financial corporations has faded from the minds of many investors. But the financial health of the NFC sector continues to deteriorate. As shown in Figure 1, our corporate financial health index (CFHI) has moved lower since we first developed it over a year ago.

As we discussed in our September 2018 report, the CFHI is a succinct distillation of eight metrics that are important determinants of corporate financial health. But perhaps a more straightforward way to think about the financial health of the NFC sector is to simply consider the ratio of corporate debt to some measure of cash flow that is available to service that debt. Many readers will be familiar with the debt-to-EBITDA ratio and its implications for debt-servicing capacity.2 Because we do not have readily available measures of depreciation and amortization on an economy-wide basis, we plot the NFC sector’s debt-to-EBIT ratio, which we consider to be a reasonable proxy for the broader debt-to-EBITDA ratio (Figure 2).

As Figure 2 makes apparent, the debt-to-EBIT ratio for the NFC sector has trended higher over the past few years and currently stands at a level that has only been surpassed in the early years of the 21st century and briefly in 2008-2009. However, one should find little consolation in the higher ratios that were reached during those periods. The spike in the debt-to-EBIT ratio that occurred in 2000-2001 and again in 2008-2009 happened during recessions. The swoon in earnings that transpired during those economic downturns pushed the overall ratio higher.

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