PMC Weekly Review - April 28, 2017

A Macro View: The Fine Line Between Boom and Bust

Global markets are at a euphoric high, reflecting optimism around President Trump’s pro-growth policies and the prospect of economic expansion. On Wednesday, the White House put the wheels in motion, declaring that President Trump would press for the largest tax cut in history—its centerpiece being a reduction of the business tax rate to 15%. In order to abstain from a political debate, let’s put aside the questions of how this plan will be funded and whether it will pass Congress and, instead, examine the economic viability of this move.

Last week, on April 19, the International Monetary Fund (IMF) released its April 2017 Global Financial Stability Report, acknowledging the gain in economic momentum since President Trump came into office. However, a key policy question raised was: Can the United States corporate sector support a safe economic expansion? According to the IMF, many firms have the capacity to increase capital expenditures, and their ability to do so will be magnified by the potential tax reforms. However, the bad news is that corporate leverage is close to an all-time high. Rising corporate leverage and increasing signs of stretched valuations pose some serious challenges to the economy and can limit the capacity of firms to expand without increasing stability risks.

According to the IMF report, the median net debt across firms in the S&P 500 is close to its historic peak of 1.5 times earnings—these firms collectively account for approximately one-third of the $36 trillion economy-wide sector balance sheet. This trend is not unique to the S&P 500: examining a broader set of approximately 4,000 firms confirms that leverage has risen to levels exceeding those just prior to the global financial crisis. To make things worse, the average interest coverage ratio—a measure of the ability of current earnings to cover interest expenses—has fallen sharply over the past two years, and earnings have dropped to less than six times interest expense. This is close to the weakest multiple since the onset of the global financial crisis.

All this comes at a time when the Federal Reserve (Fed) continues to follow through with a series of prudent rate hikes to bring interest rates back to normalization. The IMF report predicts that, under the Fed’s assumed interest rate increases, firms that account for 22% of corporate assets appear to be unable to meet their interest expenses out of current earnings. Although these firms are concentrated in the energy sector as a result of oil price volatility, the proportion of challenged firms has broadened to encompass several other sectors of the economy, such as real estate and utilities. Together, these distressed sectors account for almost half of the US investment landscape.

The US corporate sector is not doomed, but it is walking on eggshells. Looking ahead, the concerns around financial stability are twofold: the heavily indebted state of the corporate sector makes it more vulnerable to a rise in interest rates, and a reduction in tax rates is likely to exacerbate this situation by encouraging firms to engage in more risk-taking behavior. The IMF’s recommendation is to get the policy mix right, which may mean balancing stimulus and tax reform against broader policy considerations that safeguard financial stability. Reducing corporate tax rates may be a step in the right direction, but with the deregulation of the financial industry already taking place, it may be just a matter of time until the economy self corrects and finds its way to equilibrium again.

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