We expect a period of sustained high interest rates to significantly challenge corporate and government balance sheets, weighing on growth.
Alchemy
(Noun) – Any magical power or process of transmuting a common substance, usually of little value, into a substance of great value.
The rising interest rate environment of the past two years has profoundly impacted both financial markets and individual household decision making. In our last article, we introduced a new concept we call “The End of Low-Interest Rate Alchemy,” the culmination of a nearly 15-year period where consumers were able to benefit from low rates in a myriad of ways: from accessing cheap loans to benefitting from the housing market recovery and eventual boom, and also harnessing the bull market wealth effect to support discretionary spending. We concluded that going forward, the consumer faces headwinds in a way we have not seen since the global financial crisis. The consumer must now grapple with an environment where the cost of capital is, and may remain, higher than the previous decade, and do so against the backdrop of a Federal Reserve actively and purposefully working to moderate demand to achieve their price stability goals. The implications for the U.S. economy in the coming years are likely to be quite impactful, meaning potentially lower growth ahead and the consumer’s inability to pull demand forward anymore.
In this article, we expand our analysis to assess how The End of Low-Interest Rate Alchemy may impact the corporate and government balance sheets. Not surprisingly, both balance sheets expanded throughout the 2010s during the era of cheap funding. Companies are now adjusting to the higher cost of capital, but it is not affecting all businesses equally. We observe that rising rates most impact small and medium-sized businesses. For the U.S. government, default is not the concern but rather the trend of net interest costs, which have risen precipitously during the Fed’s latest hiking cycle. We take a deeper dive into both balance sheets below.
Small and Medium Sized Firms Feel the Higher Rate Heat
Over the past decade, corporations increased borrowing in part to lock in their financing at low interest rates. Case in point: The size of the investment-grade corporate market[1] has doubled since the end of 2013, expanding from $3.5 trillion to $7 trillion in outstanding bonds. Interestingly, these same issuers have shown relative immunity to higher rates, primarily due to their success in terming out fixed rate debt (note: the IG corporate market has a weighted average maturity of nearly 11 years[2]). However, this resiliency to withstand rising rates does not extend to smaller and medium-sized businesses, whose cost of funding is already higher but who also take on more floating rate debt than their larger counterparts. This trend is born out in U.S. business bankruptcy data (see below).
Rising Bankruptcies Signal a Weaker Corporate Balance Sheet
Source: Bloomberg, as of September 30, 2023
The number of new Chapter 11 business filings has risen by 15% year-over-year, in tandem with higher funding costs. Not surprisingly, banks have been tightening business lending standards in response, with senior loan officer opinion surveys showing lending practices becoming stricter across firms of all sizes (see below) and almost at levels consistent with past recessions. We believe the combination of a lower supply of loans due to tighter lending standards and less demand for debt, given the higher return bogey to make corporate projects profitable, is a structural headwind for GDP growth going forward. A weaker corporate balance sheet also means less ability for firms to supply labor, adding another challenge to the consumer we highlighted in our last piece.
Bank Lending Standards Are Consistent with near Recessionary Levels
Trend Continues Even after Regional Bank Failures Waned
Source: Bloomberg as of October 31, 2023
The Government Balance Sheet: Deficits Matter, but Rates Matter More
The health of the U.S. government’s balance sheet has been worsening for years. Of course, this is not new news to investors, but still important to highlight that the data supports this narrative. The government debt-to-GDP stands at multi-generational highs, federal outlays, and budget deficits are higher in the post-Global Financial Crisis (GFC) era versus the prior 40 years. But despite increased deficits, net interest costs have been remarkably stable. But as the chart below shows, net interest costs have increased substantially with the rise in rates.
The Government Balance Sheet: As Yields Rise, so do Net Interest Costs
Source: Bloomberg, Federal Reserve. Data as of September 30, 2023
Annualized interest is now almost $1 trillion versus less than $600 billion as recently as the fall of 2021. Unlike large corporations, the government has not effectively termed out its debt, with the largest chunk of debt in T-Bill issuance maturing next year, as seen in the chart below. With the yield curve still inverted (as of February 2024), the government is paying higher yields to issue T-bills than it would have had the Treasury termed debt out into longer maturities. Given this issuance trend, it’s unsurprising that the weighted average maturity of the entire U.S. government debt structure is just under six years versus 11 years for the investment-grade corporate market.
The U.S. Government Does a Poor Job of Terming Out Its Debt
Dependency on Near-Term Maturities Raises the Cost the Government Must Pay in a Post-ZIRP World
Source: Bloomberg
A zero-interest rate policy (ZIRP) occurs when a central bank sets its target short-term interest rate at or near zero.
What does this mean for economic growth? Increasing pressure on the government balance sheet creates more challenging choices from now on and less political will within a divided Congress to approve massive spending programs such as the CHIPS (Creating Helpful Incentives to Produce Semiconductors) and Inflation Reduction Acts. This constrains the government’s ability to spend countercyclically into recessions, unlike in past downturns when expansionary fiscal policy helped provide some offset to a weak consumer. Suppose we have indeed exited the zero-interest rate era. In that case, interest costs will remain elevated and likely increase, further constraining the ability of the government to provide a tailwind to economic growth when it’s needed most.
Conclusion
The three central balance sheets in the economy – consumer, corporate, and government – face both cyclical and structural headwinds going forward, given what we have termed The End of Low Interest Rate Alchemy. Cyclically, these trends support our view that the economy will either enter a recession or at least slow down in 2024. Structurally, an era of more normalized interest rates will constrain fiscal policy’s ability to pull forward demand. The silver lining for bond investors is that, like in the pre-GFC and Quantitative Easing era, they can access better yields to support their return goals. We are seeing this already. Corporations, consumers, and governments who can effectively manage their balance sheets in a normalized rate environment will provide fundamentally solid investment cases. As always, all balance sheets, both on a macro and micro level, are not equal. Selecting the right ones – and avoiding the deficient ones – will determine the degree of success for bond market investors in the months and years ahead.
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