Mountain of debt is holding up markets, but payment will come due in a big way, writes Mike Larson.
It’s official. The world’s biggest countries now owe more money than they did right after World War II. Debt as a percentage of GDP just hit 128% vs. 124% in 1946.
And that’s just government debt.
American corporations have borrowed a staggering $1.6 trillion in just the last few months. High-grade corporations now owe 3.53 times their core cash flow in debt. Meanwhile, lower-tier companies owe 5.42 times EBITDA. That’s the highest in modern history!
But the asset markets clearly don’t care. Interest rates on government bonds remain ultra-low. Interest rates on corporate debt remain really low.
And stocks just keep on levitating higher.
The best part here is how coverage ratios stink, debt-to-EBITDA/leverage ratios really stink, ratings downgrade-to-upgrade ratios really, really stink … yet spreads are at/near record lows. As the Guinness commercials used to say: Brilliant.
Why is this happening?
Let’s start with the debt markets. Advanced economies like ours are growing more slowly than they used to. Plus, they are getting older, demographically speaking.
In the post-WWII environment, the U.S. expanded at a rate of around 4% per year. Fast forward a few decades and GDP was expanding at just half that rate before the Covid-19 outbreak.
Slower growth tamps down inflation pressures in the real economy. An aging population fuels demand for safer assets like Treasuries.
Those are two reasons reason why every interest-rate cycle since the early-President Ronald Reagan era has topped out at a lower yield than the one before. But there’s a third reason that is just as — if not more — important keeping interest rates low:
With all this outstanding debt, if rates get too high, borrowers won’t be able to make their payments. There will be too many defaults for our economy to survive.
In short, the greater the outstanding debt, the lower peak interest rates need to be in order to “break” the economy. The best way to illustrate that is to think about the impact of a rate hike if you have a one-year adjustable rate mortgage (ARM).
Let’s say you start out with a low, $100,000 balance. Then, at the first adjustment one year later, your rate increases from 3.75% to 4%. That only boosts your monthly payment to around $477 from $463.
But with a $400,000 ARM, that same rate hike jacks your payment up from $1,852 to $1,908. That’s four times more in dollar terms — $56 versus $14.
Now, think of the entire economy, and how debt levels are much, much higher than they were in the 1980s or even 1990s. Not just adjustable mortgages, but credit cards, auto loans, corporate bonds and business lines of credit, to name a few.
All that has a suffocating influence on the economy and interest rates. Throw in a Federal Reserve that’s buying or backstopping every asset that isn’t nailed down and what do you get?
Lousy “real economy” performance but copious amounts of “asset economy” inflation. Is that healthy for our country in the long term? Of course not!
Does it present enormous profit opportunities for investors in the short-to-intermediate-term? Yes. That’s why I keep highlighting top-quality, yield-oriented, fundamentally sound companies in my Safe Money Report for investors like you.
It’s also why it’s so important for you to diversify into other investments that benefit from rampant asset inflation, like cryptocurrencies and precious metals.
Finally, be sure to understand this state of affairs won’t last forever. The longer this abnormal environment lasts — and the greater the gulf between the real economy and the asset markets gets — the more unstable the situation becomes.
We will eventually have to pay the piper for all this debt we’ve racked up, and that will lead to significant market turmoil. But I’ll save that story for another time.
My Safe Money Report focuses on these kinds of stocks, which include names in the consumer staples, food and beverage, retail, and health care sectors. Subscribe to Safe Money Report here…
