By Brian Frank
The Federal Reserve raised official interest rates four times 2018, and investors were expecting more of the same this year.
As we know, that didn’t happen. The stock market plummeted in the fourth quarter of 2018, spreads between lower-quality fixed-income investments and government bonds widened, and with an effective fed funds rate of only 2.25%-2.50%, investors, bondholders and nearly everyone else clamored for the Fed to not only give up its interest-rate hikes, but to reverse course and lower rates.
In the previous two economic cycles, the fed funds topped 5%. So why did a mid-2% interest rate prompt such distress in the U.S. economy? The answer is a whole lot of debt.
Lower rates, higher spending
Investors should be careful now that the Fed has decreased rates three times in recent months. There are two reasons why. First, companies and consumers are ignoring the opportunity to lower their debt burdens. Second, lowering rates is normally a response to economic weakness, which means jobs and profits are at risk.
The chart below shows the tremendous increase in outstanding auto loans. With the Fed lowering rates, consumers took this as a cue to gorge more by borrowing as opposed to paying down loans. Consumers are increasingly financing their cars, and rising interest rates mean higher monthly payments for more people.
Another large problem area is corporate debt. Businesses have been the biggest debt hogs in this expansion, increasing their debt by roughly 40% relative to U.S. gross domestic product, or GDP. (See chart below.) This money has gone mostly to shareholders through increased dividends and a stock-repurchasing frenzy unmatched by history.
Given these burdensome piles of debt, even a slight increase in interest rates creates millions more in interest payments for consumers and corporations.
Apple’s debt binge
What can an investor do to protect herself from the debt-party hangover? Be aware of how your investments change their risk profiles over time. Consider these tech giants:
|Company||Ticker||2008 debt||2019 debt|
|Microsoft Corp.||(NAS:MSFT)||$0||$72 billion|
|Amazon.com Inc.||(NAS:AMZN)||$0||$22 billion|
|Apple Inc.||(NAS:AAPL)||$0||$108 billion|
|Sources: Frank Capital Partners LLC, SEC filings|
Microsoft (NAS:MSFT) , Amazon (NAS:AMZN) and Apple (NAS:AAPL) , each roughly trillion-dollar companies, have borrowed more and more money in the economic expansion since 2009. While they are considered high-quality companies, it is worth noting that Apple’s revenue declined 2% in the fiscal year ended September 2019, and operating profit was down 10%. Net cash, or cash minus debt, decreased 20%, meaning that in the past 12 months, Apple used $25 billion more than what the company produced.
It’s not that Apple has lost its magic touch with consumer electronics such as the iPhone. But, clearly, the risk profile has changed with lots more debt, slowing to falling profits, and a huge market position vulnerable to economic shocks.
Too much exposure
Most other companies lack the strength and size of Big Tech but have also been overeating at the debt buffet. As real-time GDP trackers are showing slowing growth, with the U.S. expected to expand at less than a 1% annual rate in the fourth quarter, it is a great time to examine balance sheets for debt and historical company performance for exposure to economic cycles.
Just as you would head to higher ground to avoid a flood, different types of companies can offer better shelter. Of course, it is quite difficult to go bankrupt with no debt, but companies with pristine balance sheets and profitable operations are quite rare today. Instead, focus on the types of products and services that consumers and businesses must use, as opposed to those that are purchased in good times and with, you guessed it, more debt.