Financial Collapse Most Likely When Consensus Believe The Same Thing
Everything is “all good.” At least, that’s the overarching message gleaned from the price of corporate paper. The U.S. credit derivative index has reached a 10-year low, signaling extreme investor confidence in the ability of corporate America to repay its debts. We all know what happened soon after corporate paper was price this low in 2007: financial collapse.
So what is the U.S. credit derivative index, anyway? In a nutshell, it’s a measure of the creditworthiness of highly rated U.S. companies. The higher the confidence, the less compensation investors demand in return; less confidence prompts investors to demand more basis point returns (more risk).
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Right now, the index shows extreme confidence among investors. So either the investing class is right, or over-exuberance in regards to corporate balance sheets is pervasive. But which side are we to believe?
After all, corporate debt hit new highs in 2016 and shows little sign of slowing down. This happened as earnings growth slowed to a crawl, making us wonder how companies are going to finance this debt load–especially once interest rates “normalize.” (Source: “Corporate debt is at new highs, and these companies owe the most,” CNBC, April 11, 2017).
It’s all the more curious since the ratio of debt to corporate earnings usually peaks during economic downturns, not upturns. Why? Because corporate profits are lowest during the downturn, prompting corporations to borrow more to finance debt or to expand operations in anticipation of the next upturn. The fact debt is highest now, at the peak of the business cycle, is unusual.
Ultimately, the exuberance in corporate paper is just a reflection of the extreme optimism investors are experiencing today. Whether it’s retail or institutional, everyone is buying stocks and credit at levels that don’t make sense–backstopped by the Fed, of course.
We look at all these events and wonder whether any prior lessons have been learned. The answer is, of course, rhetorical.
