On Monday, shares of Moody’s Corp. (MCO, Financial) fell more than 6% after the company cut its full-year 2022 profit forecast.
The financial services firm, known for its credit rating business, investor services and financial analysis software, attributes the lower forecast to a double-digit decline in debt issuance.
Moody’s reassured investors that it currently does not expect any major downturn in economic activity. However, a decline in appetite for corporate debt this year would not necessarily show up on balance sheets immediately, just as the Federal Reserve cannot stop inflation the moment it raises interest rates. These changes take time to find their way into the markets and become known through real economic impacts.
Perhaps more importantly for investors, it signals a watershed moment for the direction stock prices could take as the combination of runaway inflation and rising interest rates wreaks havoc.
Declining corporate debt
Moody’s cut its adjusted earnings guidance range to $10.75 to $11.25 per share for the full fiscal year 2022, down from the previous guidance of $12.40 to $12.90 and lower than analysts’ forecast of $11.92. The company attributed the lower forecast to interest rates, inflation and Russia’s war on Ukraine, among other factors.
In its most recent quarterly results, Moody’s reported adjusted earnings per share of $2.89 for the first quarter of 2022, compared to $4.06 a year earlier, missing analyst estimates of $2.90. .
In an economy where inflation is growing at a healthy rate, we would ideally see corporate debt issuance increasing at a rate similar to said inflation. A decrease in debt issuance despite high inflation is a sign that companies are preparing for a full-scale recession.
This scenario was in the cards from the time the Fed cut the base rate to zero during the Covid-fueled economic downturn. With money printing, that decision was basically to borrow money in the future, and eventually it will have to be repaid.
The corporate debt bubble
One of the main reasons Moody’s remains so optimistic about the economy despite high inflation, rising interest rates and declining new debt issuance is likely because many of the warning signs traditional signs of an economic slowdown can be explained by the mechanisms of the great corporate debt bubble.
Since peaking at over 20% in 1981, the federal funds rate has fallen steadily, occasionally being raised to curb inflation before being lowered again as the U.S. economy reached territory. of the bear market.
Source: FRED (Federal Reserve Economic Data)
This means that over the past 40 years, minus a few hiccups, debt has become cheaper and cheaper, giving rise to ever higher levels of corporate borrowing. Growing or struggling businesses will borrow money, and then they will borrow even more money at lower rates in the future to pay off past debts.
Some companies have structured themselves around this mechanism to the point that their entire existence is based on their ability to take on more and more debt. If, in the future, they are no longer able to borrow more money at lower rates to pay off their existing debt, they could easily go bankrupt.
The effects of this corporate debt bubble on the economy are quite obvious; if the Fed were to raise interest rates to the sore point, it could trigger a recession the likes of which we have not seen in a century. This is why the Fed is so reluctant to act even with inflation close to 10%.
It’s also why it’s worrisome that a meager 0.25% rate hike has already cut his downside forecast, although one could argue that the drop is simply due to an abundance of caution leading a reduction in growth initiatives and acquisition agreements.
What does this have to do with stock prices?
Whether or not the economy goes into recession is a question that can only be answered by how the future unfolds. However, one thing corporate debt reduction could have a more immediate impact on is stock prices.
So what does corporate debt have to do with stock prices? As corporate debt has risen to a higher and higher percentage of US GDP, the average stock market valuation has risen in parallel. Additionally, low-interest corporate lending has helped to undermine yields on Treasuries, high-quality debt, cash and other assets traditionally considered “safer” than stocks, pushing yield-starved investors and institutions to allocate more of their capital to equity.
Considering all of these factors, we can see a clear correlation between rising corporate debt and stock prices. The higher the sustainable debt levels, the more investors are willing to treat debt as the same thing as cash on a company’s balance sheet.
The Buffet indicator (shown below), so called because it is
warren buffet The market valuation benchmark of (Trades, Portfolio) is a comparison between gross domestic product and corporate debt. The idea behind this chart is that the fair value of a country’s stock market should be in line with its GDP. As we can see, the US stock market has consistently priced above GDP since the recovery from the financial crisis, which can largely be attributed to the corporate debt bubble.
It is still too early to tell whether the reduction in new corporate debt issuance is a harbinger of recession or simply a sign that M&A activity is slowing due to a mild economic slowdown and great caution.
Nevertheless, the history of the past two decades has shown a distinct correlation between corporate debt and stock prices in the United States. Therefore, it seems reasonable to assume that a decline in corporate debt issuance could have negative effects on stock prices, as many companies will no longer have the advantage of being able to continually refinance their debt at interest rates. lower interest.