Watch Credit Markets not Chinese Tariffs

Dan Shainberg

September 17, 2018

Today's headlines of $200 billion in Chinese tariffs sent risk back into the markets. 

WSJ: "US and China Ramp Up Trade Threats"

Bloomberg: "China to Cancel Talks if Trump Moves With Tariffs"

Reuters: "China Paper Warns it Won't Play Defense"

ABC: "Trump Administration Unveils Fresh Round of China Tariffs"

Yahoo: "Stocks Wobble as Trade War Worries Deepen"

The expected market repercussions followed with the growth oriented tech sector hit hard and safe-haven assets like the U.S. dollar soaring as the 10-year Treasury yield hit 3% yet again. But these self inflicted risks can easily be reversed. Both sides are playing a game of chicken. The genie can always be put back in the hat. Once the risk/return equation changes for the parties involved, they can easily come to a negotiated settlement that calms the markets, at least according to game theory. This is all a distraction from the real risks in the global financial system ... Leverage.

Personal leverage and bank leverage are not nearly as risky as the last downturn. Most banks have seen an increase in regulatory oversight and tougher stress tests that ensure liquidity as we have somewhat learned our lesson at the financial level. The government itself has no true watchdog though and our Debt/GDP already surpassed the 100% threshold even without accounting for unfunded liabilities. 

Personal leverage has also been somewhat muted. But the corporate sector has seen a material increase in leverage and is the most vulnerable. The chart below from Morgan Stanley shows the Federal Reserve's calculations of debt at the corporate level in the U.S. as a % of GDP. The low rate environment and benign economic outlook has sent corporate officers seeking returns on equity the old fashioned way... by issuing debt to repurchase stock. 

As explained in a prior blog "The Next Recession" when a corporation issues debt to repurchase stock, they increase the Return on Equity (ROE) as the denominator usually shrinks by more than the decrease in the numerator. When interest rates are low a corporate CFO can issue debt with minimal earnings degradation. Net Income shrinks by the incremental minimal interest expense that itself is partially offset by tax benefits as interest expense is a tax deductible write-off. But the denominator decreases by more as the share count drop from the stock buyback. The effect is an immediate increase in ROE making the CFO look smart. The company can highlight their apparent growth even in the absence of true organic growth. The risk is if the trend lets you get carried away by keeping rates low for too long, and that seems to be what is happening based on the chart above. 

Debt funded stock buybacks are of course not the only culprit for the excess leverage. We also have increasing growth rates with the latest GDP print crossing 4%. That encourages more borrowing as corporate executives try to take advantage of the reported growth by issuing debt for acquisitions and capital expenditures. 

But if the economy turns south, if rate hikes force a change in our bullish perception, if Italy defaults or if some unexpected event strikes the economy as it usually does, the elevated leverage in the financial system will compound the downturn. And unlike the last decade's recession, we won't have the government's relatively clean balance sheet to provide any backstop this time. 

Dan Shainberg
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#RecessionResister
@DanShainberg