There’s more than a whiff of subprime about corporate leverage in the United States. Greater leverage correlates with lower profitability in the S&P 500 Index, I showed yesterday.
That is a disturbing observation: It means that the Federal Reserve’s years of low interest rates and quantitative easing have loaded leverage onto borrowers who are least likely to use it well. We’ve been led to believe that higher gearing multiplies profits. That’s the rationale for the nearly $1 trillion in private-equity deals in each of the past several years.
It isn’t working anymore. Low interest rates have created a huge demand for yield, and the financial industry has obliged by issuing loans to highly-levered companies and reselling them to pension funds and insurers, either directly or packaged into collateralized loan obligations.
That’s what we did with home mortgages between 1998 and 2008. The global glut of savings, as then-Fed Chairman Ben Bernanke called it, sent half a trillion dollars a year of foreign portfolio investments into the US. To meet the demand the financial industry wrote home loans to radioactive borrowers and packaged the toxic waste into opaque structures. These blew up on banks’ balance sheets and nearly took down the whole financial system.
Today’s corporate leverage poses little threat to the financial system, because the loans are in the hands of unlevered investors, rather than piled high on the books of commercial banks with 70:1 leverage as in 2008.
But too much of the debt is owed by firms with low returns on equity, that is, debtors with the least capacity to service it. That puts headwinds in front of the economy, and demarcates the point at which returns to the Fed’s easy money policy are not only diminishing but negative. Someone should explain this to President Trump and his economic team the next time they ask the Fed to cut interest rates.
In every major S&P industry sector except utilities, there is a negative relationship between leverage (defined as net debt divided by earnings before interest, taxes, depreciation and amortization) and return on equity. The higher the debt, the worse the business. That suggests adverse selection by the financial industry: Firms that are hungry for money are the least likely to use it effectively, while highly-profitable firms finance themselves internally. The profitable firms can do this because capital investment remains low by historical standards.
Below, I show the relationship between leverage and profitability for the most important S&P sectors. The charts below plot return on equity on the vertical axis against leverage on the horizontal axis. The trend line in every case slopes downward, which simply means that higher leverage, in general, corresponds to lower returns on equity.
The same is true for the Russell 2000, the small-capitalization equity index. This is a somewhat more complex case because many of the Russell companies are too small to gain access to the debt markets. Nonetheless, the trend line slopes downward and is statistically significant at the 99% confidence level.
I also noted yesterday that a dozen stocks accounted for 30% of the 2019 rebound in the S&P 500’s market capitalization during 2019, most of them the familiar tech names – Apple, Microsoft, Amazon, Facebook, Netflix, Google, Cisco and Nvidia. That makes the stock market asymmetrically dependent on
1) Facebook, whose business model of turning the customer into the product is under challenge on multiple fronts;
2) Amazon, whose stock price embodies an unrealistic investor expectation of a 30% annual growth in sales;
3) Apple, which can’t make money selling smartphones anymore and wants to fight for profits with streaming video services; and
4) Netflix, under challenge by Disney and a dozen other streaming video competitors.
I can’t think of anything wrong with Microsoft or Google, but something will no doubt occur to me. The US tech sector is populated by aging monopolies whose business model is looking a bit ripe.
Outside the tech sector, we encounter too little return on equity and too much debt. This makes the US stock market fragile, in my view. The Fed can cut rates and herd investors into the equity markets, but cheap money isn’t doing any good for profitability.