By Ross Waetzman, CIRA, CDBV, Director – Corporate Recovery
Icicles dangling from Kansas City Chiefs head coach Andy Reid’s mustache during wildcard weekend spoke to the chilly conditions gripping much of the country. For distressed-company advisors, however, conditions are heating up.
In August, I wrote that any change to distress markets would be driven by inflation (particularly wages) and the resiliency of consumer spending. At 3.9%, core inflation remains above the Fed’s 2.0% target rate. Consumer spending remains strong, only showing a modest decline in the most recent PCE report. I also previously noted that falling junk bond spreads (over Treasuries) did not indicate increased distress, a feature still true today.
Yet, corporate earnings are sliding. Expectations are that year-over-year 2023 Q4 earnings will decline. This will be the fourth decline over the past five quarters if realized. Corporate distress is distinctly percolating. Let’s explore what’s stoking the flames.
The U.S. entered an era of low interest rates in 2007 in response to a credit freeze and an overleveraged banking system. The average Fed Funds Target Rate for the 17 years prior to 2007 was 4.4%. During the following 17-year period, this rate dragged the floor, averaging only 1.4%.
Unsurprisingly, cheap rates fueled non-financial corporate (NFC) leverage. Per Gavin/Solmonese research, the 2000 – 2008 period saw a 6.8% increase in the compounded annual growth rate (CAGR) in NFC debt (source 1 & source 2). Surely corporate America learned its lesson, right? Nope. Though NFC debt grew at almost half that rate in the years leading up to the pandemic, NFC debt increased at a stunning 7.3% since 2019 and stands at a historically high 75.9% of GDP.
How did we get here (again)? As traditional lenders side-stepped “hairier” opportunities, private lenders awash in cash gladly extended credit. The advent of private lenders over the past decade has enabled this cycle of leveraging.
As interest rates rose to their highest levels since the Great Recession, business bankruptcy filings increased 29.9% last year. Still, corporate filings remain relatively subdued at levels that are 25% lower than in 2019. Enter S&P, who just stoked the fire, reporting that corporate defaults heated up by 80% during 2023.
What does this mean for 2024? Higher rates will continue to drive distress. This won’t be a repeat of 2008; lending markets are not frozen. However, pain will occur. Lessor borrowers will likely get burned refinancing cheap private loans at today’s higher interest rates. How long will this last?
Fed watchers expect six rate cuts for 2024. This is likely optimistic. Rates are high because of inflation, which remains above the Fed’s target rate. Strong consumer spending, robust corporate earnings, and near historically low unemployment do not portend six (6!) rate cuts.
Deteriorating economic conditions (i.e., a recession) could merit multiple rate cuts. Understandably, this is not the playbook that less financially stable debtors seek to shore up bloated balance sheets and porous P&Ls. It is enough to simmer the zombie soup currently cooking on the stove.
In summary, the system has a good amount of pent-up distress. For those advising on matters of distress, look for a continued heat-up in 2024.