- The U.S. nonfinancial private sector's financial vulnerability declined below its historical average as of first-quarter 2021 to -1.31, its lowest level since 2011.
- Timely public policy responses improved financial conditions for both households and businesses after an initial liquidity shortage at the start of the pandemic.
- While the average family and business is better off, wealthy households and large corporations may have enjoyed bigger balance sheet improvements.
- The ongoing stock market boom may impair U.S. financial stability, but it's hard to define asset bubbles at the start of a business cycle recovery.
The U.S. nonfinancial private sector's financial fragility is now below its historical average. Corporate and household balance sheets have strengthened, mainly a result of timely government support during the pandemic and the quick rebound in economic activities thanks to the successful vaccination rollout and the accompanying reopening.
As of first-quarter 2021, S&P Global Economics' Financial Fragility Index (FFI) declined to -1.31, from -0.01 at the end of 2019, confirming the short duration of the COVID-19-led recession and the ongoing recovery. Both the nonfinancial corporate FFI and the household FFI have fallen significantly since the COVID-19 outbreak, with the former at -0.64 and the latter at -1.98 as of first-quarter 2021.
For corporates, similar to the global financial crisis (GFC), leverage heightened while liquidity deteriorated at the onset of the recession, but this time financial risks were quickly relieved by public policies. Unlike the GFC, households headed into the pandemic with a much lower debt burden, lowering the possibility of financial repercussions after the economy was locked down. Households' extremely low financial fragility at present is driven both by sustained deleveraging activities since the GFC and further strengthening in households' financial conditions during the pandemic, led by generous fiscal supports.
Corporate Financial Resilience Improved Despite An Initial Liquidity Shortage
For the nonfinancial corporate sector, the initial pickup in financial fragility was quickly relieved by generous monetary and fiscal policies, albeit at the cost of more public debt. The nonfinancial corporates FFI declined to -0.64 in first-quarter 2021, reaching the lowest level since 2012, after an initial tick-up to 0.6 in 2020 from the prepandemic level of 0.3.
The uptick of corporate financial fragility in second-quarter 2020 was led by more borrowing during heightened economic uncertainty, but partly offset by improved liquidity, thanks to timely public policies. As uncertainty around economic activities went up, corporates needed more credit to maintain operations during the lockdown. Therefore, corporates borrowed from government relief programs set up by the Federal Reserve and the Treasury, leading to higher leverage and lower interest coverage ratios. Meanwhile, the initial liquidity shortage was quickly relieved by various Fed lending facilities. Despite the sudden rise in short-term rates in March and April, all liquidity indicators improved in second-quarter 2020, offsetting part of the risks from higher leverage(1).
From second-quarter 2020 to first-quarter 2021, the economic outlook became clearer and the U.S. economy recovered to its prepandemic status. Liquidity indicators stabilized and leverage indicators improved, bringing financial fragility down. Notably, the Fed has been selling the assets acquired by its temporary credit facilities since the end of 2020, and we didn't see a second pickup in the financial vulnerability of the corporate sector, indicating solid improvement of corporate balance sheets(2).
Household Financial Fragility Declined To A Historical Low
For the household sector, thanks to the persistent deleveraging process post-GFC, U.S. families headed into the pandemic with relatively healthy balance sheets, which were strengthened further by fiscal policies during the pandemic. The household FFI dropped to -1.98 as of first-quarter 2021, declining from the already low level of -0.31 as of end-2019. So far, the household FFI has been under its historical average since 2010 (see chart 4).
That said, we did see the household FFI tick up to -0.23 in first-quarter 2020, from -0.31 as of end-2019. Last spring, massive layoffs left 17 million more folks jobless in March and April, leading to a sudden decline in households' liquid assets and net worth(3). Fortunately, the index reverted direction in second-quarter 2020, stimulated by three rounds of stimulus checks, skyrocketing housing prices, and a stock market boom that has pushed the S&P 500 index to an all-time high of 4,300 as of June 30.
While The Average American Firm And Family Is Better Off, Some Are Left Behind
The FFI describes well how the balance sheets of many American firms and households have evolved since the pandemic. However, there are still important groups of economic participants that are not so well described by our index.
Indeed, our index tells the story of the average American firm and family. For businesses--although not all private businesses are corporate--the corporate sector holds 70% of total assets owned by U.S. businesses, according to the Federal Reserve Board. More detail on financial conditions by sector would likely show a much wider array of "haves" and "have nots". For households, tax rebates are sent to every family, regardless of their financial status. However, wealth effects should be more relevant to those that own homes and/or have a substantial share of their portfolios invested in stocks. In 2019, the homeownership rate in the U.S. was 65%, according to the U.S. Census Bureau, while 55% of Americans owned stocks, per private consulting firm Gallup(4). Therefore, although wealth effects are not the same for everyone, they indeed would affect most nonfinancial private participants in the U.S. economy.
That said, larger businesses and wealthy families are likely to be financially better off. Firstly, many small businesses that were hit hard in the pandemic may have permanently closed, despite unprecedented government relief. A recent study by the Federal Reserve Board estimated that business exit rates were over 33% above normal during 2020, with the smallest businesses (those with fewer than five employees) and the more labor-intensive and people-facing leisure and hospitability industry hit the hardest(5). Secondly, low income families have substantially lower home and/or stock ownership rates than high income families. Only 51% of low income families owned their houses in 2019, according to the Census Bureau. Meanwhile, merely 22% of adults in families earning less than $40,000 a year owned stocks, according to Gallup. In contrast, 85% of folks with family income of more than $100,000 a year claim stock ownership(6).
Stock Market Boom: Wealth Accumulation Or Bubble Risk?
Although the ongoing stock market boom, a major driver of households' financial improvement in our index, indicates wealth accumulation for stock investors--who are also households--some may worry that skyrocketing stock prices may lead to asset bubbles that add another dimension to households' financial fragility. Albeit a possibility, it would be hard to define the current stock market boom as a bubble.
Looking at recent history, the market-to-book ratio has always picked up one or two quarters after a recession ends, except after the dot-com bubble. Among other things, this could be led by base effects of asset prices, improvements in leverage and liquidity, and, most importantly, a resurgence in investors' risk appetite in expectation of stronger future income growth against a solid economic recovery.
Indeed, the improvement of our liquidity and leverage indicators explained part of the faster growth in market-to-book ratios in the past six months. This is quite reasonable, because fewer responsibilities to debt holders directly equal more income for equity holders in the future. However, as noted earlier, the forward-looking market-to-book ratio may also reflect a resurgence of investor confidence. A large portion of the increase in market-to-book ratios in the past six months is not explained by improvements in leverage or liquidity and could be due to expectations of improving profitability against the backdrop of a clearer U.S. economic outlook and a more inflation-friendly Fed. This is similar to what happened after recessions in the 1980s and 2010s. Whether such expectations are over-optimistic remains to be seen, because, among other things, the development of vaccination rollouts and the spread of the Delta variant are still sources of uncertainty.
That said, the unprecedentedly high saving rate and low household debt at present may encourage more money flowing to risky asset markets, not just the stock market, further building up asset prices and creating sources of risk(7).
Getting A Birds-Eye View With The Financial Fragility Index And The National Financial Condition Index
Although the nonfinancial private sector is an important determinant of U.S. financial stability, to get a more comprehensive view, one should also look at the financial sector. The Chicago Fed's declining National Financial Condition Index (NFCI), at -0.64 in first-quarter 2021, indicates the improving resilience of the financial sector, including financial markets and major institutions(8).
The NFCI and FFI could serve as complements when one tries to examine the financial stability of the U.S. economy from a bird's eye view. Specifically, FFI measures the financial resilience of the nonfinancial private sector. NFCI, on the other hand, describes the overall financial market, measuring whether financial conditions are tighter or looser than the historical average. In other words, it measures how easy it is for borrowers to access funding from the financial market.
The pictures these two indices paint are different, but related. The financial health of households and nonfinancial firms is reflected in the cost of borrowing prevailing in the market. The conditions of financial markets could also affect borrowing behaviors of households and firms. Therefore, the two indices are directly correlated, reflecting this two-way causal relationship. What's more, real sector financial conditions and financial market conditions could both be the results of shocks coming from a third source, for example, COVID-19. We could see that the two indices almost move together, syncing with the pace of lockdown and reopening in 2020 and 2021.
Understanding the Financial Fragility Index
For readers to better understand our Financial Fragility Index, we describe the index's structure in this section. The index is a weighted average of indicators that reflect the financial fragility of corporates and households from different perspectives. We use principal component analysis to construct the index. The index includes not only the indicators at present but also their recent history to account for the possibility that financial risk may take time to mature and affect the economy.
We depict the fragility of nonfinancial corporates in two aspects: leverage risk and liquidity risk. We chose three indicators (interest coverage ratio, net debt to EBIT, and debt to asset ratio) to directly reflect leverage risk, and two indicators (liquid asset to short-term liabilities and short-term debt as a percentage of total debt) to directly monitor liquidity risk. We included two extra indicators, market to book ratio and return on assets, to indirectly reflect leverage as well as liquidity risks, because of the high correlation between the above two indicators and leverage/liquidity risk indicators. Intuitively, profitability, reflected by return on assets, relates to borrowing activities, while market valuation, reflected by the market-to-book ratio, indicates investors' assessment of firms' leverage, liquidity, and profitability.
We examine the financial fragility of households in three dimensions: leverage risk, liquidity risk, and wealth effects. Similarly, we chose four indicators (debt service ratio, debt to disposable personal income, loan to value ratio, and charge-off rate on consumer loans) to reflect leverage risk. We chose two indicators (liquid assets to short-term liabilities and short-term debt as a percentage of total debt) to reflect liquidity risk. As an increase (decrease) in households' wealth is going to lower (heighten) leverage and/or liquidity risk, we include net worth to debt ratio as an indicator of wealth effects.
The two indicators for nonfinancial corporates and households are then grouped into one to form an aggregate Financial Fragility Index. We assume financial conditions would mostly affect durable consumption and residential investment for households, nonresidential investment for nonfinancial corporates, and that the share of GDP relevant to the financial fragility of households and firms respectively is roughly the same over 1960-2020. Therefore, we take the average of the indices for both sectors to form an aggregate index for the total private nonfinancial sector.
1) For example, the three-month 'AA' nonfinancial commercial paper rate went up to 1.83% in late March and early April 2020, from 0.88% in mid-March, even after the Fed lowered the target range of the federal funds rate twice to 0-0.25%. Similarly, three-month LIBOR went up to 1.4% in late March and early April, from 0.74% in mid-March.
2) Namely, the Secondary Market Corporate Credit Facility and the Term Asset-Backed Securities Loan Facility.
3) Although they didn't show up in the March job market data, many of the layoffs may have happened in March as the Employment Situation Report by the Bureau of Labor Statistics collects information in the week containing the 12th of each month, leaving the rest of the month captured by the numbers about the job market in the next month.
4) Saad, Gallup, "What Percentage of Americans Owns Stock?", September 2019
5) Crane, Decker, Flaaen, Hamins-Puertolas, and Kurz, Federal Reserve Board, "Business Exit During the COVID-19 Pandemic: Non-Traditional Measures in Historical Context", April 2021
6) See note 4
7) The Fed's Financial Stability Report periodically checks asset valuations, including those of housing, equity, bonds, and crypto assets.
8) The NFCI does contain two out of 150 indicators describing nonfinancial firms' and households' balance sheets. The household debt outstanding/PCE durables and residential investment ratio, and nonfinancial business debt outstanding/GDP ratio. However, the weights assigned to these indicators are rather small.
The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.
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:||Shuyang Wu, Beijing|
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