- Financial cycles matter for real economic activity. As part of our business cycle surveillance, we use a principal component analysis technique to track and assess overall "balance-sheet" vulnerability of the U.S. nonfinancial private sector.
- We developed a Financial Fragility Index for Households (HH) and Nonfinancial Corporates (NFC) separately, each capturing seven key macrofinancial metrics (from the Federal Reserve's Financial Accounts of the U.S.) deemed important determinants of the respective sectors' health.
- The HH Financial Fragility Index is below its historical mean, while the NFC Financial Fragility Index is meaningfully above its historical average. The vulnerability of NFC sector has increased steadily over the past year. Debt in the sector has grown faster than underlying economic growth, its reliance on short term debt has increased, and profit margins are well past their peak (and stagnated since 2015).
- Further deterioration in the NFC sector's financial health is likely as a tougher profit environment will make reduction in interest rate coverage more acute. Investors' sentiment--and therefore asset prices--might also suddenly change, leading to further deterioration in the sector's financial health.
As of the second quarter of 2019 (according to the latest available data), the HH Financial Fragility Index was a 0.5 standard deviation below its historical mean (see chart 1), while the NFC Financial Fragility Index was one standard deviation above its historical average (see chart 2).
Taken together, these two indices don't seem to indicate the risk of a serious macroeconomic dislocation just yet (see chart 3). Still, by itself, the NFC sector over the past few years has evolved to become much more vulnerable versus historical norm. Identifying the magnitude of any particular driver is beyond the scope of this S&P Global Economics analysis, given the purely statistical nature of the exercise; however, observations from past financial cycles have shown a strong link between debt accumulation and subsequent debt service, which, in turn with duration of the expansion, increases vulnerability to sudden shocks and therefore negative effects on growth. (1)
The vulnerability cycle (see charts 1 and 2) offers both a gauge of the resilience of the ongoing expansion, as well as a means to track the ability of households and businesses to withstand any shocks to the system (should they arise). For the NFC sector, our financial fragility index captures principal components derived from metrics that together represent three major sources of macrofinancial imbalances (which often interact with each other): (1) high leverage (systemic default risk), (2) inflated asset valuations relative to underlying cash flows (bubble risk), and (3) high dependence on short-term financing (liquidity risk). The HH sector index is derived from similar metrics that can be bucketed in (1) and (3) above. In place of (2), we incorporate a measure that reflects the wealth effect, or the theory that consumers spend more as the value of their assets rise, even if their income and fixed costs remain the same (see tables 1 and 2).
|Indicator Components For The Household Sector|
|1)||Debt service ratio|
|2)||Debt to disposable personal income|
|4)||Liquid assets to short-term liabilities|
|5)||Short-term debt as a percentage of total debt|
|6)||Net worth-to-debt ratio|
|7)||Charge-off rate on consumer loans|
|Note: Refer to charts 4-10 for above indicators.|
|Indicator Components For The Nonfinancial Corporate Sector|
|1)||Interest coverage ratio|
|2)||Net debt to EBIT|
|3)||Liquid assets to short-term liabilities|
|4)||Short-term debt as a percentage of total debt|
|5)||Return on assets|
|Note: Refer to charts 14-20 for above indicators.|
We use Principal Component Analysis (PCA)--a data transformation method--to express multivariate data into one summary variable. The goal of the method is to reorient the data so that we can summarize a large set of original variables with relatively few components that capture the maximum possible information (variation) from the original variables. (2)
We normalize both the HH and NFC Index series (setting the historical mean at zero and the standard deviation at one) over the available period extending back to 1987. Therefore, positive values represent higher-than-average financial vulnerability within the NFC or HH sector, while negative values represent lower-than-average financial vulnerability, meaning the sector's financial health is in a relatively good shape.
Looking back in history, the financial fragility of the nonfinancial private sector generally picked up as the business cycle matured, peaked in the middle of a recession, and plunged at the beginning of a new round of expansion.
Still, this is not to say that the deterioration in macrofinancial health of the two sectors will necessarily be followed by an overall economic contraction. The Fed can extend financial resilience (at least temporarily) by alleviating balance-sheet pressures through the easing of monetary policy and regulation. However, whether such an accommodative stance is enough to sustain the expansion still depends on the extent balance-sheet health can improve before financial conditions tighten again.
The current situation appears similar to the mid-1990s in many ways. Both are characterized by contained inflation risks and a solid job market. Further, the Federal Reserve Open Market Committee (FOMC) now puts even more emphasis on the data-dependent approach to better respond to incoming information with appropriate policy adjustments. Back in the 1990s, the Fed offered insurance rate cuts to support the economy and successfully extend the expansion. Similarly, this year, as global uncertainties kept rising, the FOMC has shifted toward a lower rate path and cut rates to boost the outlook.
How do these two indices compare with the widely used Chicago Fed's National Financial Conditions Index (NFCI)? We take a simple average of our NFC and HH Index and plot it against the NFCI (restandardized quarterly average using the same sample period starting from 1987). Our composite index directionally tracks well with NFCI--it shows a smoother lead time on accumulating imbalances compared with NFCI's sharp turns with little lead time, and it is more sensitive to the interest rate (see chart 3).
Where Do Household Balance Sheets Stand As The U.S. Approaches The Mature Stage Of Expansion?
High leverage (systemic default risk)
The massive deleveraging relative to income growth on the part of American households in the aftermath of the financial crisis has brought aggregate household indebtedness--measured as the debt to disposable income ratio--to levels seen back in 2001, after peaking at the end of 2007 (see chart 5). Additionally, thanks to low interest rates during the current expansion, the debt service ratio (DSR)--measured by debt service payments as a share of disposable personal income--has fallen even faster and largely eased the debt burden of U.S. households (see chart 4). From its record high of 13.2% in late 2007, the DSR declined to less than 10% in 2012. As of the second quarter of 2019, the DSR fell to its lowest point of 9.7% in available history. This relatively low ratio bodes well for households' ability to tolerate financial shocks.
The loan-to-value ratio (mortgage debt to the value of real estate) is at its lowest since the first quarter of 1991 (see chart 6). The painful debt overhang resulting from a surge in mortgage borrowing and a collapse in housing prices is finally no longer dragging on economic growth by restraining spending. In terms of consumer loans, the charge-off rate has slightly increased since it bottomed in 2015; yet the latest reading of 2.3% is still below the historical average of 2.4% (see chart 10).
To better incorporate the "wealth effect" into the balance-sheet analysis, we use the net worth-to-debt ratio (see chart 9) in our fragility index. A high net worth-to-debt ratio suggests that households' wealth level is supportive of wealth effect. That ratio is now sitting at cyclical high due to the deleveraging and a net worth boom. A similar net worth-related measure is the net worth to the disposable personal income ratio (see chart 11). The rebound after the Great Recession has been largely driven by the stock market's recovery, and, since 2014, also the improvement in home prices generally.
The households' liquid assets to short-term liabilities ratio has also improved due to income growth and stock market recovery (see chart 7). Meanwhile, the continuous pick-up in the short-term share of the total debt indicates that nonmortgage loans have been growing faster than mortgages (see chart 8).
Overall, the household sector remains in relatively decent shape to withstand potential financial shocks. Quantitatively, the financial fragility is now about a 0.5 standard deviation below its historical mean. Yet the "flow of funds" data only provide an aggregated picture of the sector; therefore our summary index developed based on this data lacks the income distribution factor, which in reality matters more to individual households.
In that regard, distributional effects on returns to economic growth, as measured by household income and wage growth, have improved as the expansion has now become the longest in history. Since the crisis, real mean household income has recovered at all income quintiles (see chart 12), and lower-wage occupations have finally realized a higher pace of wage growth compared with the median (see chart 13).
Indicators Of Household Macrofinancial Fragility Index
Where Do NFC Balance Sheets Stand As The U.S. Approaches Mature Stage Of Expansion?
The NFC sector experienced a much faster fragility build-up after the financial crisis than households. As interest rates stay lower for longer, businesses have been willing to take on more debt to finance their operations.
High leverage (systemic default risk)
The net debt-to-EBIT ratio has started to pick up since the end of 2014, which was its lowest point (2.26) for the current expansion (see chart 15); as of the second quarter of 2019, the ratio reached 3.72. Though it is still below its peaks in previous recessions, such leverage build-up is unambiguously undermining the resilience of the sector to potential financial turmoil. In the meantime, total leverage, measured by total debt to total assets, hasn't seen major swings during the current expansion (see chart 19).
The interest coverage ratio remains above its historical average (4.2x) (see chart 14), offsetting the leverage build-up. The Fed's policy normalization has contributed to the decline in the coverage ratio since the end of 2017, but the most recent wait-and-see stance of monetary policy may help stem the recent decline in the coverage ratio.
Investors remain optimistic about corporate earnings growth, as evidenced by the market-to-book ratio (see chart 20), which remains near cyclical high. The latest number came out at 1.81 (for second-quarter 2019), a level last seen 20 years ago in the same quarter. However, with the effect of recent tax cuts waning and tail risks for economic growth rising, peak profitability is now behind us (see chart 18).
The liquid assets to short-term liabilities ratio has come down from its cyclical high at the end of 2017 (see chart 16). The current level of 0.76 as of second-quarter 2019 is right below the average of the current expansion, yet higher than most readings for the last expansion. The short-term share of total debt has also been ticking up around the same period (see chart 17). The latest reading stood at 31.5%, the same as where it was at the beginning of 2007.
We see rising risks from the uptick in leverage, inflated asset valuations relative to underlying cash flows, and the high dependence on short-term financing, justifying the result of our NFC Financial Fragility Index of about 1 standard deviation above the historical average. Similar to the household sector, wealth inequality is also a problem for American companies--a 2017 study by S&P Global Ratings (based on the companies we rate) estimated that more than half of the liquid assets is controlled by the top 1%, therefore leaving a less positive financial position and higher credit risk at the margin for the other 99%.
In the near future, the Fed's policy decisions may help ease financial conditions and stem the increasing trend (temporarily) in the sector's financial fragility. Yet with debt in the nonfinancial business sector growing faster than underlying economic growth, as well as the interest-rate coverage and earnings outlook declining, sudden changes in investors' sentiment and therefore asset prices may lead to further deterioration in the sector's financial health.
Indicator Components Of Household Macrofinancial Fragility Index
- Next Debt Crisis: Earnings Recession Threat, Sept. 30, 2019
- The Expansion Of The 'B-' Segment Is Feeding Growing Vulnerabilities, Sept. 25, 2019
- U.S. Business Cycle Barometer: Recession Risk Rises, Aug. 15, 2019
- U.S. Corporate Cash Reaches $1.9 Trillion, But Rising Debt And Tax Reform Pose Risk, May 25, 2017
- U.S. Households' Deleveraging May Finally Be Coming To An End, July 28, 2014
(1) Financial cycles can span more than one business cycle. In the past, the fragility of the financial cycle has tended to increase over time, with the peak tending to usher in recessions, but not all recessions are preceded by such peaks.
(2) The idea of Principal Component Analysis (PCA) is to extract a smaller set of linearly uncorrelated principal components to explain a "high" amount of the cumulative variance of the original data--i.e. to present a huge dataset using a smaller number of variables without losing too much information. In our case, we ran a PCA of year-over-year changes of seven balance-sheet indicators, together with four time variants for each indicator, over a sample period starting from first quarter of 1986 until the second quarter of 2019. Such analysis helps to identify the four most important "common factors" among the indicators, and cumulatively they explain more than 70% of changes in the vulnerability of the nonfinancial private sector's balance sheets. We then weighted each principal component based on its variance explanatory power and summarized accordingly into one fragility index for each sector.
This report does not constitute a rating action.
|U.S. Chief Economist:||Beth Ann Bovino, New York (1) 212-438-1652;|
|U.S. Senior Economist:||Satyam Panday, New York + 1 (212) 438 6009;|
|Contributor:||Lei Yi, New York (1) 212-438-3494;|
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