The warning lights are flashing.
The IMF, not the organization that Tom Cruise works for in all the Mission Impossible movies, recently issued a report cautioning the world about the risks U.S. companies are facing.
According to their latest Global Financial Stability Report – the ability of these businesses to cover their interest payments on borrowed cash is at its weakest since 2008’s financial crisis.
The warning comes at a time when the President is planning to jumpstart growth in the economy through tax cuts and economic spending. And while these are good things, the IMF believes that Trump’s policies could end up increasing borrowing costs – putting US companies at even greater risk.
What’s the extent of the problem?
The debt burden for the US corporate sector has noticeably increased. The amount of debt that US businesses are carrying is as much as 40% of income.
To put that into perspective, that’s like if you worked in a job earning $50,000 and borrowed $20,000.
This percent has increased quite a bit and is approaching levels only seen before a recession occurs. While it doesn’t mean a recession is going to happen, it does indicate that we should be wary. It’s like walking out on the surface of a lake in winter when you can see through the ice – you’ll want to be careful.
Source: IMF Global Stability Report
As can be seen above, the corporate debt service ratio is somewhat correlated with the prime lending rate. This prime lending rate, which is tied to the Fed Funds rate and is the interest rate that banks charge each other, gives us an idea of how expensive it is for banks to borrow money. When this rate goes up, money tends to dry up as banks choose not to borrow, or they in turn increase the rates they charge to customers and businesses to cover their costs.
The worry is that when this rate goes up, it will make servicing debt more difficult, and the current political conversation is all about when and whether the Fed will increase the Fed Funds rate. Just by looking at the chart you can see that it’s been basically stagnant since 2009.
It doesn’t end there.
US companies, as a group, are not only borrowing more but their ability to pay has gone down too.
Source: IMF Global Stability Report
The graph above shows the ratio of EBIT, earnings before interest and taxes, to interest payments for US corporations. When the blue line above dips, it means that either earnings are decreasing or interest payments are going up.
Luckily the IMF figured out which: it’s both.
There are a couple of factors all playing out concurrently. At one end the amount of cash that businesses are holding is decreasing, down to 4% of total assets. At the same time, corporate profits are declining. They reached great heights in the years following the crisis but have since lost their head of steam. Corporate profits are around 11.5% of GDP, down from nearly 13%.
So profits are generally down, but debt financing has increased too.
Either way, it means that the stress of making interest payments is increasing. US companies are feeling the flop sweat forming on their collective brows. According to the IMF, since 2010 businesses across the country have added $7.8 trillion in debt and assorted liabilities to their balance sheets. That’s about 40% of overall US GDP (18 trillion).
The IMF put all this together and in their estimate, 22% of total US corporate assets are considered to be very vulnerable in the event of a continued increase in borrowing costs. That represents $4 trillion. They also found that the weakest patches were in the energy, real estate and utilities sectors.
The round up
So it doesn’t look good, but we have to understand that a lot hinges on what happens in the future and how Trump’s policies play out.
Here are the big bullet points on the expected plan.
- Cut the corporate tax rates from 35% to 15%
- Lower the tax rates for millions of small businesses
- Increase the amount of the standard deduction people can claim on tax returns, from $6300 and $12,600 (individuals and couples) to $15,000 and $30,000
- Increased infrastructure spending
- New childcare tax credit
Whether these policies pass in their entirety is what will have the greatest effect on US businesses and their ability to pay back borrowed funds. Financial giant JP Morgan has come out publically and said that the plans will be “virtually impossible to pass through Congress”. Politico stated that Trump’s plans are so optimistic that it could actually hijack the conversation of tax reform and making it impossible to get any changes made at all.
What is more likely is that the proposed plans are bold for one reason, to anchor the negotiations. The financial industry appears to expect reduction in the corporate tax rate of just 8%, from 35% to 27%. That would be a win for them – forget about getting it to 15%. The expectations are also that no changes will end up being won for individuals.
It the President gets what he wants, then it will be a burden on the government. The Tax Policy Center states that reducing the corporate tax rate alone, from 35% to 15%, would cost the federal government $215 billion in one year, becoming more expensive every following year.
If government deficits start to balloon, it could lead to higher inflation and higher interest rates across the board – leading to, you guessed it, increased borrowing costs for US businesses.
We’re far from having the final answer, but let’s keep our eyes and ears open.