LIBOR’S LABOR

Three-month LIBOR rates have more than doubled to 2.3% in the last year and have jumped seven fold in the last 30 months. According to Bloomberg, about $350 trillion of financial products and loans are linked to Libor, with a large chunk hinged to the dollar-based benchmark. In the past, spikes in LIBOR rates have coincided with peaks in business activity followed by sharply declining sales momentum. Meanwhile, the Fed has been raising its own benchmark and plans 2 or 3 more hikes this year.

Rates are rising along the whole curve:

Fiscal negligence, courtesy of world central banks!

The reality for anybody with floating rate debt and/or fixed rate debt maturing in coming years is skyrocketing interest expense over the next several years and the necessity to start planning for it:

U.S. corporate debt to GDP is at a record level, exceeding levels previously reached during recessions. Corporate debt is now 25% of cash flow, higher than during the Financial Crisis as this chart from Ed Yardeni illustrates.

High debt levels may be palatable when interest rates are abnormally low but can quickly become a burden when rates and serviceability are rising. Leverage does work both ways.

Since 1992, debt leverage peaked at 2.2x during recessions. It is now 2.44x with 76% of borrowers levered more than 2.0x.

We thus have record debt levels relative to revenues (GDP) and record leverage relative to cash flows nine years into the economic cycle and with record high profit margins. This when the Fed is tightening, labor capacity is stretched and the consumer, 70% of total demand, is squeezed by rising prices and record low savings rates. Maybe the word complacency should spell conplacency.

While economists and strategists continue to dismiss recession odds and statically calculate the effect of rising interest rates, corporate treasurers are actively discussing various scenarios for 2019-2022 with their CFO and COO, all of which showing sharply higher interest expense and potentially significant re-financing challenges amid the widely expected crowding out from the U.S. federal government and central banks’ normalization process (see WITH THE KING OF DEBT, CASH IS KING).

Treasurers are also pointing out that the recent tax reform is not friendly to interest expense on an after tax basis. A 100 bps increase in interest rates is really 122 bps with the new lower tax rate. From a debt servicing point of view, the tax bill is actually increasing an already high corporate leverage and the potential earnings bite from higher interest rates.

High yield default rates may be historically low at its current 2.0% but as Moody’s explains

each time the moving yearlong average of operating profits drops by 5% or deeper from its earlier maximum, the high-yield default rate eventually climbs up to at least 5%.

While tax reform provides a one-time boost to 2018 after tax profits, trends in pretax results will dictate corporate behavior in coming quarters.

The current high indebtedness and leverage combined with sharply rising interest rates are not unnerving the debt market just yet but history shows that optimism (or complacency) rarely gets any better. Analysts rarely perform dynamic analysis incorporating rising interest rates and refinancing needs, matters rarely disclosed during corporate conference calls. The stealthy rise in financing costs goes unnoticed…until it really starts to bite and credit spreads widen rather swiftly.

In the mean time, smart corporate executives are already beginning to adjust their business to the developing threats, curbing spending and maximizing cash flows, leading other less levered or less foresighted companies, eventually feeling the slowdown in revenues, to do the same. Employment slows or declines, spending budgets and capex plans are trimmed. Business sales start to wane, competition increases, operating margins are under pressure right when financial costs begin to rise. Dividend payouts are reviewed and stock buybacks reduced in order to protect cash and credit ratings.

This corporate dynamic explains why spikes in interest rates often lead a slowdown or a decline in corporate profits even absent a recession. The process is exacerbated by the now widespread corporate focus on quarterly results and profit margins,

And if and when employment gets meaningfully impacted, consumer spending begins to wane as well, which is when monetary and fiscal flexibility can be very handy…Getting some flexibility in monetary policy is currently a prime target for the Fed but is several hikes away. Fiscal flexibility is nowhere in the minds of the current administration and Congress, quite the opposite.