HERE IS WHERE THE NEXT CRISIS WILL START

25 March 2022

After the last sub-prime crisis and 15 years of QE, Brexit dislocation from UK's main market, climate change and the Energy Transition away from fossil fuels, Covid and yet more very serious business disruption, now war in Europe with sanctions ejecting the world's only full-spectrum commodity and agri producer ... where will the next crisis come from? 

Many have savings in stock markets. There seems to be a growing problem in the credit markets. 

If you look at household and corporate debt, by region (US, Euroland and China), there are some serious hotspots in companies' debts in the US; Euroland and the UK are not great but OK;  though in China, both company debt to assets ratio, and profits to interest payments ratios, as well as household debt to household income, are all really worrisome with spreads (see below) averaging 12%.

The ratings agencies tell you the confidence you can have in a loanee. And central banks publish heat maps.

The yield on a bond or loan is made up of a fixed risk-free rate that everyone gets, unless a floating rate which is regularily reset, then add on a credit risk (the risk of the company defaulting) and a liquidity risk (the difficulty of selling the loan), according to the investment grade. It is the latter two that make up the credit spread, so zero for gilts and t-bonds, but increasing with decreasing loan quality or "investment grade".

"Investment grade" is BBB or above. Most funds have a policy that says only investment grade is permitted. Or you can buy high yield. Half the loans in a fund are in the bottom triple-B tranche, just above junk, reflecting the reality of corporate quality.

There is a real problem in leveraged floating loans. There is a real problem when these loans are bundled up. They will contain mostly triple B because that is the quality of most loans, but in a recession, these would be downgraded to junk ("high yield", if you prefer ha ha), obliging fund managers to sell  these bonds...

Seeing a recession, many will start heading for the exit, anticipating company downgrades by the rating agencies.

Companies will face higher rollover rates, increasing their costs ... so lowering their profits ... the company gets a downgrade ... so rollover rates go up again ... and the problem compounds across equity markets from bad to good companies. 

Share price follows expected earnings, at least in the short term. Earnings downgrades and we have a stock market crash as everyone heads for the exits.

So if analysts begin to anticipate a recession - the war, no, but inflation and higher lending rates, yes - then we'd be in this "downgrade cascade" and there is little or nothing central banks could do.

The next crisis could well be a stock market crash and it would start in the credit markets. . 

So it means we must at a minimum check debt levels of any companies we own and sell before a downgrade.

Questions: 

Cannot withdraw to cash because inflation will devalue your savings, so what do "safe" assets look like?

What is a reasonable ratio of debt/equity or a EBIT/interest payments? 

Will Value outperform Growth? 

What of unexciting stocks with safe balance sheets paying say a GT 4% divi?