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Next Debt Crisis: Earnings Recession Threat

(Editor's Note: A full list of contacts is provided in Appendix 4 )

Corporate leverage is worsening in 2019 as debt rises faster than earnings for nonfinancial companies. S&P Global Ratings believes faltering profit growth threatens an earnings recession. This in turn may be a leading indicator of an economic recession. Indeed, after evaluating a variety of factors, our economics team recently raised the risk of a U.S. recession in the next 12 months to 30%-35%.

Weak earnings threaten to drive up corporate leverage. Chart 1-1 indicates that debt and earnings rose in tandem between 2011 and 2017 for a global sample pool of 20,071 nonfinancial corporates (largely unrated). But the trend diverged in first fiscal-half 2019: debt growth jumped while that of earnings fell. Similarly, for our rated portfolio, we project debt will expand faster than earnings in 2019 (see chart 1-2).

Chart 1-1

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Chart 1-2

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Debt rise.   Could the higher debt growth in early 2019 be an anomaly? The trend could have been driven by two market developments. First, borrowers returned to market after having been sidelined by a partial shutdown in the U.S. noninvestment grade corporate bond market in the fourth quarter of 2018. Second, lenders and investors perceived signals from the U.S. Federal Reserve in the first quarter 2019 as indicating a "lower for longer" environment. Taken together, we have willing borrowers and willing lenders.

Early warning indicators.   We chose a large sample size (20,071 companies) to capture medium-sized enterprises in the study. Such enterprises are more likely than their established larger counterparts to serve as the "canary in the coal mine". Indeed, 85% of the sample (based on borrower count and debt amount) is unrated by S&P Global Ratings (henceforth "the unrated sample"). We believe the default rates are likely to be higher in the unrated sample than in the rated portfolio. The sample's gross debt of US$30 trillion is equivalent to a substantial two-fifths of the estimated total global nonfinancial corporate debt of US$73 trillion.

Rated portfolio.   As previously alluded, rated corporates tend to be larger than most of those in the unrated sample. This advantage allows rated companies to borrow more relative to size yet enjoy more robust profit margins. Indeed, we project earnings growth of the rated portfolio will improve in 2019 over 2018 (while earnings growth of the unrated sample is declining). However, debt growth of the rated portfolio will also exceed that of earnings (see chart 1-2). More positively, we expect the debt growth rate to moderate to below that of earnings in 2020 and 2021.

Geographies.   In the unrated sample, the Asia-Pacific region (chart 2-1) is the primary driver for weaker global earnings growth. We see this phenomenon as tied to China's economic slowdown. Europe (chart 3-1) and Latin America (chart 4-1) are largely flat while North America (chart 5-1) has gone off its recent peak. (Charts for the 10 largest countries or economies by GDP are provided in Appendix 2).

Chart 2-1

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Chart 2-2

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Chart 3-1

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Chart 3-2

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Chart 4-1

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Chart 4-2

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Chart 5-1

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Chart 5-2

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For the rated portfolio, charts 2-2 to 5-2 show historical trends and our projections by geographic region. For Asia-Pacific (chart 2-2); Europe, Middle-East and Africa (chart 3-2); and Latin America (chart 4-2), we expect earnings to grow slightly ahead of debt over the next two years. For North America, the debt build-up from recent mergers and acquisitions (M&A) activity is expected to wind down (chart 5-2), translating to improved leverage. Our projections are base case. In a downside recessionary scenario, compressed earnings could reverse leverage improvements.

Sectors at risk.   Charts 6-1 to 8-1 show three industry sectors which face heightened credit risks. These are auto (chart 6-1 for the unrated sample and chart 6-2 for the rated portfolio), consumer products (charts 7-1 and 7-2), and retail (charts 8-1 and 8-2).

Chart 6-1

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Chart 6-2

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Chart 7-1

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Chart 7-2

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Chart 8-1

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Chart 8-2

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Automotive.   The global car industry has lost its main growth engine. Contrary to initial expectations that the setback in the Chinese market would be temporary, sales volumes have now been declining for almost a full year. Prospects of a recovery in the second half of the year are dim.

Consumer products.   Liquidity and weak growth prospects underpin the negative outlook bias (i.e, more negative rating outlooks and CreditWatch listings than positive), particularly for speculative-grade issuers. Challenges include refinancing risk, constrained liquidity, and unsustainable capital structures.

Retail.   In North America, specialty retailers continue to see declining customer traffic and promotional pricing pressure, resulting in unsustainable capital structures or narrowing liquidity. In Europe, the high street remains under pressure, with pockets of improvement. Apparel and department stores have faced negative pressure for the past two years.

Additional sectors.   The top-five rated sectors where credit risk is highest (as measured by our net negative outlook bias) are, by region:

  • Asia-Pacific: Automotive, consumer products, gaming, telecoms, and transport cyclical (see report on credit conditions in Asia-Pacific published Sept. 30, 2019).
  • Europe: Automotive, steel, technology, real estate, and transport infrastructure (airports) (see Credit Conditions EMEA, Sept. 30, 2019).
  • North America: Automotive, consumer products, healthcare, retail, and pharmaceuticals (see Credit Conditions North America, Sept. 30, 2019).

(Charts for additional industry sectors are provided in Appendix 3).

Broader universe.   We see the unrated sample as reasonably representative of the wider universe of corporate borrowers. Chart 9 illustrates the macro picture: corporate debt rose faster for the first calendar quarter 2019, while 2019 nominal GDP growth is expected to fall. We presume a co-relationship between nominal GDP growth and earnings growth.

Chart 9

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Chart 10

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Rating trends.   Chart 10 shows the net outlook bias for our global rated corporate portfolio. The worsening ratings outlook trend, which started in third quarter 2018, has been a forward indicator of corporate credit trends. One obvious manifestation of such a trend has been the recent decline in earnings growth.

Default correlation.   There appears to be some correlation, albeit imperfect, between the "highly leveraged ratio" of the unrated sample and the annual speculative-grade default rates of our rated portfolio (see chart 11). In chart 12, we show the rising trend of U.S. corporate issuers rated 'B-' and below as a percentage of speculative-grade issue ratings. Past trends have indicated that a profusion of new 'B-' ratings is a leading indicator of default rate spikes (see "The Expansion Of The 'B-' Segment Is Feeding Growing Vulnerabilities," published Sept. 25, 2019). (Highly leveraged is the lowest classification of our six-tier leverage risk categories).

Chart 11

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Chart 12

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Low interest rates.   The decade-long low interest rate environment has helped sustain the debt-servicing ability of corporate borrowers. Chart 13 shows the trend in the ratios of debt-to-EBITDA and funds from operations (FFO)-to-debt for the corporate sample. The FFO-to-debt ratio mean has been largely flat while the debt-to-EBITDA mean has worsened. This is explained by the FFO-to-debt ratio being computed on an after-interest expense basis and the debt-to-EBITDA ratio before. In short, the leverage fundamentals would look worse if not for the prevailing low interest rates.

Chart 13

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China riskiest.   The leverage of the unrated sample slightly worsened in first-half 2019 compared with 2018 (see chart 14). Same result when compared with 2015, the most recent trough in global nominal GDP growth (see chart 10). Among geographies, China's corporates (note: some are government-related entities which benefit from potential state support) have the largest absolute debt and, within the unrated sample, the highest risk mix. While China's leverage did hold steady in first-half 2019, the continuing economic slowdown there is likely to apply some pressure. The risk distribution in Europe and the United States remains better than in most emerging markets.

Chart 14

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Related Research

  • Trade Tensions Rumble Through Asia-Pacific's Credit System, Report Says, Sept. 30, 2019
  • Credit Conditions North America, Sept. 30, 2019.
  • Credit Conditions EMEA, Sept. 30, 2019.
  • Credit Conditions Latin America, Sept. 30, 2019.
  • Credit Conditions North America, Sept. 30, 2019.
  • The Expansion Of The 'B-' Segment Is Feeding Growing Vulnerabilities, Sept. 25, 2019
  • Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Is Set To Rise To 3.4% By June 2020, Aug. 23, 2019
  • Economic Research: U.S. Business Cycle Barometer: Recession Risk Rises, Aug. 16, 2019
  • Credit Trends: A Weakening Economic Outlook And High Leverage Raise Global Corporate Downgrade Prospects, July 30, 2019
  • S&P Global Ratings Publishes North American Mid-Year Corporate Credit Outlook And Industry Top Trends Report, July 25, 2019
  • European Corporate Credit Outlook Mid-Year 2019: A Switch In Time?, July 25, 2019
  • Uncertainty Returns To Asia-Pacific Credit Conditions, Report Says , June 27, 2019
  • Next Debt Crisis: Will Liquidity Hold? , March 12, 2019

Appendix 1: The Data Behind The Charts

Data and information behind charts 1-1 to 8-1.

Table A1

Data And Information Behind Charts 1-1 To 8-1
Countries, economies
Sample is drawn from 51 economies described by the International Institute of Finance (IIF) as mature markets and emerging markets i.e.
Asia-Pacific
Australia, China, Hong Kong, India, Indonesia, Japan, Korea (South), Malaysia, New Zealand, Pakistan, Philippines, Singapore, Taiwan, Thailand.
Europe
Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Russia, Spain, Sweden, Switzerland, Turkey, Ukraine, United Kingdom.
Latin America
Argentina, Brazil, Chile, Colombia, Mexico
Middle-East Africa
Egypt, Ghana, Israel, Nigeria, Saudi Arabia, South Africa, United Arab Emirates.
North America
Canada, the U.S.
Sample debt amount
US$30 trillion gross debt of which:
Asia-Pacific ex-China, US$5.0 trillion
China, US$8.1 trillion
Europe, US$6.4 trillion
Latin America, US$0.9 trillion.
Middle-East and Africa, US$1.1 trillion
United States, US$8.5 trillion
Sample financial data source
S&P Global Market Intelligence
Sample industries
Auto, building materials, capital goods, chemicals, consumer products, forest products, healthcare, homebuilders, infrastructure, media, metals & mining, oil & gas, REITs, retail, services, technology, telecoms, transport and utilities.
Sample size
20,071 nonfinancial corporates (85% unrated) of which:
Asia-Pacific ex-China, 8,597
China, 4,719
Europe, 2,825
Latin America, 625
United States, 2,200
Other economies, 1,105

Table A2

Data And Information Behind Chart 9
Credit data source
Bank for International Settlements (BIS) except for S&P Global Ratings' projected 2019 based on Q1 2019 data from the International Institute of Finance (IIF)
GDP data source
International Monetary Fund (IMF)

Table A3

Information Behind Chart 10
Net outlook bias computation
We calculate the net outlook bias by deducting the percentage of negative outlooks and CreditWatch listings against the percentage of positive outlooks and CreditWatch listings. A minus figure indicates that the percentage of negative outlooks and CreditWatch listings exceeds the percentage of positive outlooks and CreditWatch listings; and a positive figure, vice versa.

Table A4

Data And Information Behind Charts 11 To 14
Debt
For purposes of computing the leverage ratios, we deduct 50% of cash from gross debt to arrive at adjusted debt.
Default rates
Annual default rates drawn from S&P Global Ratings' Annual Global Corporate Default And Rating Transition studies.
2019 projection based on Credit Trends: A Weakening Economic Outlook And High Leverage Raise Global Corporate Downgrade Prospects, published July 30, 2019.
Geographic weightings
In order to avoid sample size bias, each economy's sample is weighted based on the economy's nonfinancial corporate debt as estimated by the Bank for International Settlements (BIS) when aggregated up to the regional or global level.
Leverage ratios
The two leverage ratios are debt-weighted averages of categorized debt-to-EBITDA and FFO-to-debt ratios:
EBITDA-- earnings before interest, tax, depreciation and amortization.
FFO--funds from operations (EBITDA less net interest expense less tax).
Leverage thresholds
We divided corporate leverage levels into six categories based on the average of the country debt-weighted averages of the debt-to-EBITDA and FFO-to-debt ratios. The categories of "minimal,", "modest," and "intermediate" indicate lower risk while "significant," "aggressive," and "highly leveraged " indicate higher risk. The category thresholds are shown in table A5.

Table A5

Leverage Thresholds Applied To Sample Financials
Standard leverage ratios For real estate For utilities
FFO/ debt (%) Debt/ EBITDA (x) FFO/ debt (%) Debt/ EBITDA (x) FFO/ debt (%) Debt/ EBITDA (x)
Minimal 60+ <1.5 >20 <2.5 35+ <2
Modest 45 to 60 1.5 to 2 15 to 20 2.5-4.5 23 to 35 2 to 3
Intermediate 30 to 45 2 to 3 9 to 15 4.5-7.5 13 to 23 3 to 4
Significant 20 to 30 3 to 4 7 to 9 7.5-9.5 9 to 13 4 to 5
Aggressive 12 to 20 4 to 5 <7 9.5-13 6 to 9 5 to 6
Highly leveraged <12 >5 >13 <6 >6
FFO--funds from operations (EBITDA less net interest expense less tax).

Appendix 2: Geography: Debt And Earnings Growth Trends

Chart B1

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Chart B2

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Chart B3

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Chart B4

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Chart B5

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Chart B6

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Chart B7

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Chart B8

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Chart B9

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Chart B10

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Appendix 3: Industry: Debt And Earnings Growth Trends

The charts below display the debt and earnings growth rates for the rated portfolio by industry sector.

Chart C1

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Chart C2

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Chart C3

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Chart C4

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Chart C5

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Chart C6

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Chart C7

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Chart C8

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Chart C9

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Chart C10

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Chart C11

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Chart C12

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Chart C13

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Chart C14

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Chart C15

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Chart C16

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Chart C17

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Chart C18

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Chart C19

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Chart C20

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Chart C21

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Chart C22

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Chart C23

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Chart C24

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Chart C25

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Chart C26

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Appendix 4: List Of Contacts

Table A6

Contacts Of Contributors
Corporate Ratings
Global Gregg Lemos-Stein, +1-212-438-1809, gregg.lemos-stein@spglobal.com
Asia-Pacific Anthony J Flintoff, Melbourne +61-3-9631-2038; anthony.flintoff@spglobal.com
Europe, Middle-East and Africa Alex P Herbert, London +44-20-7176-3616; alex.herbert@spglobal.com
North America Michael P Altberg, New York +1-212-438-3950; michael.altberg@spglobal.com
Jeanne L Shoesmith, CFA, Chicago +1-312-233-7026; jeanne.shoesmith@spglobal.com
Credit Markets Research
Global Sudeep Kesh, New York +1-212-438-7982; sudeep.kesh@spglobal.com
Credit Research
Global Alexandra Dimitrijevic, London, +44-20-7176-3128, alexandra.dimitrijevic@spglobal.com
Asia-Pacific Terence Chan, Melbourne, +61-3-9631-2174, terry.chan@spglobal.com
Emerging Markets Jose Perez-Gorozpe, Mexico City, +52-55-5081-4442, jose.perez-gorozpe@spglobal.com
Europe, Middle-East and Africa Paul Watters, London, +44-20-7176-3542, paul.watters@spglobal.com
North America David Tesher, New York, +1-212-438-2618, david.tesher@spglobal.com
Economics
Global Paul F Gruenwald, Singapore +1-212-438-1710; paul.gruenwald@spglobal.com
Asia-Pacific Shaun Roache, Singapore +65-6597-6137; shaun.roache@spglobal.com
Emerging Markets Tatiana Lysenko, Paris +33-1-4420-6748; tatiana.lysenko@spglobal.com
Europe, Middle-East and Africa Sylvain Broyer, Frankfurt +49-69-33-999-156; sylvain.broyer@spglobal.com
North America Beth Ann Bovino, +1-212-438-1652, bethann.bovino@spglobal.com
Ratings Performance Analytics
Global Nick Kraemer, New York +1-212-438-1698; nick.kraemer@spglobal.com

This report does not constitute a rating action.

S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).

Primary Credit Analyst:Terry E Chan, CFA, Melbourne (61) 3-9631-2174;
terry.chan@spglobal.com
Secondary Contacts:Alexandra Dimitrijevic, London (44) 20-7176-3128;
alexandra.dimitrijevic@spglobal.com
Paul F Gruenwald, New York (1) 212-438-1710;
paul.gruenwald@spglobal.com
Gregg Lemos-Stein, CFA, New York (44) 20-7176-3911;
gregg.lemos-stein@spglobal.com

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