Everyone seems to be in a bit of a debt bind at the moment: The US government has run out of credit to spend, high inflation and interest rates have taken a big bite out of debt-laden tech companies that expected pandemic-era growth to continue and US credit card debt reached nearly $1 trillion in the fourth quarter of 2022, according to TransUnion.
Last year was bad for credit on all counts as Covid-zero policies in China, Russia's war on Ukraine and the associated energy crisis and high inflation led to turbulent markets, pushed up borrowing rates and slowed the global economy.
Economists are hoping that this year brings better news, but 2023 is unlikely to provide the clean break investors are hoping for. Governments have diminishing fiscal options to deploy after piling on debt during the pandemic and individual borrowers face a prolonged period of elevated interest rates.
Profit pressures on corporate borrowers, meanwhile, are intensifying at an especially rapid pace as business costs remain elevated while consumer demand wanes amid the prospects of an economic downturn.
High borrowing costs and an uncertain economic outlook mean that companies are trading in the prospect of rapid growth for smaller debt loads. Fourth-quarter earnings reports show that the pace of debt reduction accelerated to -1.6% for the year, from -0.9% in the third quarter, according to Bank of America.
But businesses that don't have cash to pay down debt loads may face the music in 2023. Economists at S&P Global Ratings forecast that speculative-grade (perceived to have a lower level of credit quality compared to more highly rated, investment-grade, companies) corporate default rates in the US and Europe will double this year alone.
So are we on the brink of a corporate credit crisis?
Before the Bell spoke with Ruth Yang, managing director and global head of thought leadership at S&P Global Ratings to discuss what lies ahead for the corporate credit market.
Before the Bell: What's your big picture view of the credit economy right now?
Ruth Yang: There's no easy way out, we have a very narrow pathway forward. If we have a shallow and short recession, then the risk for defaults is also shallow and short. But if we have a longer recession — even if it's shallow — and growth continues to slow, we're going to see defaults start to rise and credit markets struggle.
Corporations still have cash cushions on their balance sheets but they're getting eaten away, we're running out of time and the pathway is narrowing. As it narrows exogenous macro shocks present larger risks to the credit markets. It could be the destabilization of crypto, or the tension between energy security and the cost of energy and climate change or US-China relations and supply chain problems.
All of these things are going to come at costs and the impact is really magnified because we don't have a lot of margin for error. We don't have a lot of room to maneuver and we have a lot at risk.
How are you seeing credit headwinds playing out in investment strategies?
'Higher for longer' interest rates isn't just about borrowing costs. Something I've noticed is that it's also impacting funding strategies in general. Private equity investors and others are no longer as focused on total return and are less willing to fund companies that are cash-flow negative in the short term. They're going to be a lot more focused on cash-flow-positive companies across the board. We think that will change sector-based investment strategies — technology and health care are notoriously cash-flow negative and will have more trouble finding funding.
Who will lead the way in these possible funding changes?
Private equity fuels an enormous part of our economy and the ability to get funding is going to lead the way in corporate earnings reports. The maturity wall for debt is still a few years down the road but if we're still in a 'higher for longer' state in two or three years we're going to have to fundamentally change how we fund companies. The business models of companies that are able to raise funds will also change. There will be slower growth with thinner margins and that's going to change how people look at their investment opportunities.
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