US Corporate Sector Runs Dry of Capital. What to Expect Next

Market Commentary
July 6, 2023

By Acuity Trading

The Federal Reserve has finally paused rate hikes, after its monetary tightening for 10 consecutive meetings. This has left the US corporate sector with a deadweight of debt.

 

The Backstory

The Fed kept interest rates artificially low, cutting them to a range of 0% to 0.25%, during the pandemic. While this allowed financially stressed companies to stay afloat, the government pumped billions of dollars into the economy to boost demand. As a result, debt default rates in the US fell below 1% in 2021 and bankruptcies declined by 12% in 2022. This situation quickly reversed with the Fed’s aggressive rate hikes to a range of 5% to 5.25%.

 

The Unquenched Thirst for Credit

Against the backdrop of incessant rate hikes came the collapse of Silicon Valley Bank, with customers withdrawing deposits of a whopping $42 billion in less than 48 hours. The failure of other financial institutions resulted in the clawback of banking loans. Banks are now less willing to lend, making it tougher for companies to access credit. 

 

Several banks across the country, both domestic ones and the US branches of foreign banks, are now following tighter lending criteria and more stringent terms for lending. Apart from economic uncertainty, reduced risk tolerance of borrowers, and deteriorating industry-specific conditions, these banks are cited their worsening current and expected liquidity position as a reason for holding back lending. 

 

The lending criteria for small and medium enterprises were the first to be tightened. The least creditworthy businesses and those that need credit the most were the first to suffer. Small business loan approvals at big banks declined from 13.8% in March to 13.5% in April and then again to 13.4% in May, according to the Biz2Credit Small Business Lending Index. Further, the approval rates of business loan applications at small banks dropped from March’s disappointing figure of 19.1% to 18.7% in April. This means banks are rejecting more than eight of every ten business loan applications they receive.

 

The current credit crunch resembles that seen during recession and will impact even those companies that have managed their finances strategically over the past three years. According to the Federal Reserve’s latest Senior Loan Officer Opinion Survey (SLOOS), many of these banks widely expect to further tighten their lending over the rest of 2023. 

 

The Double Whammy 

Even when banks do lend, businesses have to bear a much higher cost of capital due to the interest rate hikes. On the other hand, consumer spending has declined steeply, amid stubbornly high inflation, high interest rates, and recession fears. As revenues lag, cost pressures persist, and fewer bank loan approvals restrict access to capital, companies are strapped for cash.

 

On the Other Side of the Pond

The situation in the EU and UK has not helped the cause. After Germany, the Eurozone’s largest economy, went into recession, there was little hope for the remaining countries that are part of the bloc. Declining consumption pushed the Eurozone into an economic slump, while the ECB continues with its monetary tightening measures. Meanwhile, the Bank of England, which was the first to begin raising interest rates, is not yet done. 

 

Corporate Debt Defaults

Although the US government has averted a debt default, businesses in the country continue to face this risk. Close to 250 corporate bankruptcies have been filed since the beginning of the year. This is double the number of Chapter 11 filings in the first six months of 2022, and the highest since 2010. In May, seven large companies filed for bankruptcy in less than 48 hours. This is the highest number of Chapter 11 filings for companies with at least $50 million of liabilities in a two-day period since 2008. Among these are retail behemoths Bed Bath & Beyond and JCPenney as well as ecommerce platform Boxed, KKR & Co’s Envision Healthcare Corp, and media darling Vice Media. Consumer discretionary companies were the busiest filers, followed by industrials, financials, and healthcare sectors.

 

The Outlook

The ticking debt bomb is a serious concern. Any respite seems even more distant after Federal Reserve Chairman Jerome Powell’s comments warning that rate cuts are “a couple of years out.” In fact, there are rising speculations of the US central bank hiking interest rates again by 25 basis points at its July meeting.

 

During times of recession, the Fed has historically eased its liquidity requirement to allow banks greater flexibility to hold lower reserves, although this increases their vulnerability. The case is the reverse now. The largest banks, like Morgan Stanley and Citibank, have started adding to their reserves to prepare for a bleaker future. The Fed really has no wiggle room here.

 

On the other hand, the US economy has exhibited great resilience in many ways. Despite the aggressive rate hikes, the job market has been far better than feared, despite the Fed’s aggressive rate hikes. Also, many households still have savings from their covid-19 stimulus packages, which is holding up demand. Wages are also higher now, which can fuel spending. 

 

The IMF expects economic growth to decelerate to 1.6% in 2023, from 2.1% in 2022. Although low, this is still growth. Morgan Stanley analysts also believe the US will avert a recession, although there is “turbulence on the horizon.” The market sentiment for both S&P 500 and Nasdaq 100 remains bullish, as can be seen in Acuity’s AssetIQ Widget.  Investors should look out for XYZ (yield curve inflection evolution) as to whether a recession will play out.

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