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The U.S. credit cycle is at a dangerous turning point

Tonhe celebrates At 204,000 words, French economist Thomas Piketty’s tome Capital in the Twentieth Century is even longer than Homer’s Odyssey. But the book’s central argument can be distilled down to a single three-character expression: r > g. As long as ‘r’, the real rate of return on capital, exceeds ‘g’, the real economic growth rate – over the course of the 20th century, as Mr Piketty calculates – then inequality will widen.

The simplicity of the message has won Mr Piketty widespread praise. It also spawned the popularity of economic expressions. An influential rule i > g is a variant of the Piketty rule. It applies when the nominal interest rate (or risk-free return) exceeds the nominal growth rate. A troubling conclusion to be drawn from this expression applies to debt. In a world where i > g, the income, wages, or tax revenues earned by debtors will grow more slowly than the interest they accrue on their borrowing, implying that debt levels have the potential to explode.

A world where i > g is foreign to the United States and most of the West. Nominal growth rates have been higher than nominal interest rates since late 2009 (except in the first half of 2020, when the covid-19 pandemic collapsed the economy). Now America is about to cross the threshold. Strong annualized real economic growth of 4.5% in the first quarter of 2023, while disturbingly high inflation means nominal gross domestic product At an annualized rate of 8.3%, it easily beats nominal interest rates of around 5%. A group of economists surveyed by data firm Bloomberg expects growth to slip to just 0.4% in the second quarter of this year, with inflation falling to 3.3%. Nominal growth is expected to be only 3.7%, well below nominal growth of around 5.2%.

“This is when rubber really hits the path of the business cycle,” notes Carl Riccadonna bnp BNP Paribas, a bank. “If you’re a business, your revenues are growing at a slower rate than your funding costs right now.” Wage growth will lag debt growth. Government interest payments will grow faster than tax revenues. A quarter of that is probably tolerable. Unfortunately, economists expect this to continue for a year or more.

The exact impact depends on the extent to which debt is repriced when interest rates rise. The vast majority of US homeowners have 30-year fixed-rate mortgages. The generous financing will protect them from the pincer combination of slower wage growth and higher interest payments. However, consumers with other types of debt, including revolving credit card balances and private student loans, will feel the pinch.

Many companies hold both fixed-rate and floating-rate debt, which means they’re also somewhat insulated. But their debt maturities tend to be much shorter than their mortgage terms. A significant portion of corporate fixed-rate debt will be rolled over in 2024. Businesses preparing to refinance are starting to get nervous. Raphael Bejarano of investment bank Jefferies noted that many corporate treasurers have been shocked by the difficulty of raising debt over the past year. “Many of them are looking at a large debt due in 2024 and trying to pay some of that debt down earlier, even at higher interest rates,” he said. What they are really afraid of is not being able to pay their debts at all.

The companies most at risk include many that have recently been bought by private equity tycoons. The private credit loans received by their firm’s portfolio companies often carry floating interest rates. During the last major credit cycle, in 2008, many private equity firms were able to maintain their over-leveraged acquisitions by negotiating with lenders, mainly banks. This time, they will go head-to-head with private lenders, many of which also employ large private-equity teams and are more than happy to take on overleveraged companies. May 16th, a harbinger of things to come kkrEnvision Healthcare, a large private equity firm that invested $3.5 billion in its portfolio company in 2018 at a valuation of $10 billion, was driven into bankruptcy and seized by its lenders.

When looking at the picture, it is reassuring to note that interest rates have been high for some time, the US economy is doing pretty well, and even bank failures appear to be skin wounds rather than fatal wounds. But all of this is happening in a different context. It’s much easier to swallow high capital costs when matched with the aforementioned high returns on capital. This situation will not last long.

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