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The End of the Credit Lifeline?

January 13, 2020

We passed the first phase of a China trade deal, the Federal Reserve is cutting rates, there are no ominous signs of a recession, corporate earnings were strong, the S&P 500 was up 27 percent in 2019…no reason to worry, right?

Wrong.

To see where the stock market is headed, look at credit markets. Problems arise there first before spreading to the rest of the economy.

The corporate bond market houses $10 billion in corporate debt, which is an all-time high whether measured nominally or as a percent of gross domestic product. When, not if, this market bubble pops, it will likely infect the rest of the economy.

See, corporate debt activity is fueled by firms that don’t make enough money to service their debt, but continually borrow money to stay afloat. That’s not sustainable over time. As companies default on their debt, an avalanche of bankruptcies typically follows.

But companies aren’t defaulting because low interest rates keep cheap money available and there clearly isn’t a shortage of willing lenders, as balance sheets loaded with debt will attest.

This has the Fed’s fingerprints all over it and is short-lived. The day of reckoning will come. Many firms don’t have the cash to pay down their debt. So, either defaults will rise, or debt will come down. If it’s the former, it won’t be a happy ending.

This all seems like a giant house of cards. Firms have taken on more debt than ever, and the credit quality is the lowest it’s ever been (nearly 1,000 North American firms were downgraded in 2019).

Some companies are completely dependent on the credit market. Once there’s enough fear in the chain and somebody stops the lending, the house could tumble.

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