$6.6tn corporate debt could trigger US recession

The surge in corporate debt could be the catalyst for a US recession, warns Joe LaVorgna of Deutsche Bank: "The corporate sector has taken on a substantial amount of debt in the current business cycle; non-financial corporate debt has increased by $2tn from its trough in Q4 2010." Earlier this month, S&P found that by the end of 2015, corporate debt at the 2,000 largest US companies had risen to $6.6tn, up from $3.8tn at the end of 2010. LaVorgna points out that corporate debt as a percentage of GDP has now reached a level only previously seen just prior to the two most recent recessions, and warns that with this level of outstanding debt the present tightening of lending standards and costs could have a significant impact: "An over-tightening of credit conditions would be problematic for a highly levered corporate sector, especially if final demand were to remain weak." Yesterday, the World Bank cut its worldwide growth forecasts for the next three years, warning the "insipid" recovery coincided with the dangerous build-up of corporate debt.

Talk of a recession dominated market analysts' conversations during the swoon that started 2016, but it started fading into the background after the market recovery.

According to Joe LaVorgna of Deutsche Bank, however, in addition to slowing jobs growth and weakening economic data, there is a huge reason to worry about a recession: debt.

"The corporate sector has taken on a substantial amount of debt in the current business cycle," LaVorgna wrote in a note to clients. "Non-financial corporate debt has increased by $2 trillion from its trough in Q4 2010."

A breakdown from analysts at S&P earlier this month found that corporate debt had risen at the 2,000 or so largest US firms to $6.6 trillion to end 2015, up from $3.8 trillion at the end of 2010.

According to LaVorgna's breakdown, corporate debt as a percentage of gross domestic product has reached a level previously seen only just before the two most recent recessions.

"The ratio of non-financial corporate debt to nominal GDP is at its highest level since Q2 2009, when the economy was still in recession and nominal output was substantially depressed," he wrote.

"This is one reason why the Fed needs to be very cautious with respect to the pace of policy normalization."

Deutsche Bank

This also becomes an issue as the cost and standards for lending become tighter. As we noted, the most recent report on bank lending standards showed loan officers tightening those standards. As LaVorgna outlines, with the amount of debt outstanding, this tightening of conditions could have a huge impact.

"An over-tightening of credit conditions would be problematic for a highly levered corporate sector, especially if final demand were to remain weak," he said in the note.

"If capital costs were rising in an environment of declining margins, employers would at minimum slow the pace of hiring, and perhaps even cut labor outright. This may already be occurring, given the broad-based weakness of the May employment report."

The idea here is that as it becomes more expensive for companies to service debt, they will cut back on labor costs. In turn, consumers stop spending as they get worried about their jobs, and this decreases income for businesses, creating a cycle of slowing ending in recession.