INSIGHTS

On May 13, 2019

Liquidity and Leverage, Forever Dance Partners

With the tariff two step currently being displayed between the United States and China, it is easy to overlook two components of a late-stage economic cycle that often foreshadows the severity of the next downturn. While the downturn does not appear imminent, it is still an event that one should be prepared for as the capital market prices will price it in before the actual occurrence. 

The two components that should be first and foremost on the focus list is liquidity and leverage. In each recession, both components have led to an ultimate downturn and predicated the severity of each event. The measurement of each category must be done with a bit of an artistic versus an absolute eye as each expansion and recession has its own unique hue in its portrait. 

There are many forms of liquidity and leverage and they can change direction promptly. It is therefore important to have multiple focal points in liquidity and leverage and perhaps more importantly, the proper context. Consumers and Corporates are the two largest components of the economy and give us the basic framework from which to view leverage from an economic perspective. 

The consumer has been in balance sheet repair mode for the last decade. The Financial Crisis imparted a “quasi-permanent” shift in consumer behavior that still has not seen a reversion to previous late stage euphoric manifestations. The consumer, the largest driver of the economy, should be looked at on the asset and debt side. 

Since the end of the last recession and through 2018, Household Debt has grown 1.51% annually, Household Net Worth has grown 6.38% annually and Household Total Deposits have grown 3.92% annually. 

As such, the ratios of various Household Debt to other economic measures has shown significant deleveraging. 

On the Corporate front, we have seen a bit of a divergence in various forms. The proliferation of corporate debt has risen as has certain liquidity metrics for the overall corporate market. 

The immediate need of liquidity via commercial paper has been all but non-existent in its growth and each recession also showed cyclical highs. The current measure of 20% commercial paper outstanding to total investment grade corporate debt has been manipulated with the proliferation of debt, however the decline is far more precipitous than the rise in the debt. There is not an immediate need of money from the capital markets from the tepid hiring rate, the tax breaks of 2018 and massive corporate buybacks. This is also corroborated with the Corporate Financing in Gap. When positive, corporates are needing to access capital markets to make up deficits which is the case 73% of the time since 1950. Only 27% of the time over the last 68 years are corporations able to fund their spending with internal cash flow, as we have been over the last four quarters. 

As we saw in the Household Balance Sheet Data, the S&P 500 has seen a significant shift in balance sheet and debt profiles. While not at more historic levels of lower leverage, it has increased substantially since the end of the Financial Crisis. 

The markets have taken for granted the lowering of leverage in the two areas where we have traditionally been the most vulnerable. The escalation in these metrics has forced us to have a longer-term perspective to properly balance out the leverage measurements in their current form. It is nearly futile to look at data that only shows the last decade as we have only known expansion during that time frame. I use the expansion term very loosely as it has had periods of very anemic growth during that time frame. 

So as the market attempts to balance out the tit-for-tat tariff scuffle, the markets will continue to have downward pressure. To be fair, market gyrations have over-reacted many times during this expansion ultimately to set new highs; therefore, it is prudent to have a more static allocation model and longer-term horizon. The leverage and liquidity metrics often walk in lock step, and currently both are pointing to a bit more expansion. 

CRN: 2019-0501-7408R