Corporate debt, interest rates and political uncertainty spook global markets

Australian Financial Review Mar 28 2018 4:30 PM

Karen Maley

How's this for a toxic cocktail for global sharemarkets? Take high levels of corporate leverage, add in rising interest rates and a large dollop of political uncertainty, and it's a recipe guaranteed to shake investor confidence.

Let's take each of these ingredients in turn. Close to a year ago, the International Monetary Fund warned that US corporate debt had ballooned to levels exceeded those prevailing just before the global financial crisis, as US firms had taken advantage of ultra-low interest rates to load up on debt.

The IMF warned that elevated corporate debt levels could cause problems down the track, as the US central bank continued to push short-term interest rates higher. But the warning went completely unheeded, as easy credit conditions spurred a fresh round of corporate debt raising in 2017.

US corporates, however, aren't the only big borrowers. European and Chinese companies have similarly loaded up on debt. In a report released in February this year, S&P Global Ratings warned that the proportion of highly leveraged corporates – those whose debt stood at more than five times their earnings – had climbed to 37 per cent in 2017, compared to 32 per cent in 2007, on the eve of the financial crisis.

S&P Global Ratings warned there was a risk that a fresh default cycle could commence as the world's major central banks removed the "easy money punch bowl" by hiking short-term interest rates and winding back their massive bond buying programs.

Worries about the sustainability of corporate debt burdens are now seeping into the global equity markets.

This week, Tesla's share price slumped as ratings agency Moody's downgraded the electric car maker's credit rating and warned that it will likely need to tap capital markets in the near future so that it can repay the $1.2 billion in debt that it has maturing by early next year and to cover its "large negative free cash flow".

Borrowing costs rise

The problem that debt-laden corporates face, however, is that their short-term borrowing costs are now climbing even faster than US official interest rates.

The three-month Libor (the London interbank offered rate) spiked to 2.3 per cent this week, its highest level since November 2008. Libor, which measures how much it costs banks to borrow from each other, is used as the benchmark on about $US200 trillion ($260 trillion) in borrowings worldwide.

Libor has been inching higher since the end of 2015, when the US Federal Reserve drew the curtain on its seven-year experiment with near-zero interest rates. The Fed's key short-term interest rate target is now 1.5 to 1.75 per cent.

But in the past six months, the Libor rate jumped by nearly a full percentage point, outstripping the Fed's rate rises in the same period. Some analysts blame Libor's spike on rising short-term bond sales by the US government, but others point out that sharp rise in Libor is always a sign of increased strain in the global financial system.

There are good reasons for the increased market stress. The US sharemarket was sent reeling earlier this month after US President Donald Trump threatened to impose tariffs of up to 25 per cent on $US60 billion of Chinese goods, and limiting China's ability in the US technology industry.

Although many investors are hopeful that Washington's threat was only a bargaining chip to improve US access to Chinese markets. access easing, the market remains extremely apprehensive about rising geopolitical risks.

At the same time, a cloud is now hanging over US technology stocks, which were formerly market darlings. Since early February, Facebook's share price has tumbled by more than 20 per cent.