Monday, August 21, 2017

Leverage is not a sign of risk seeking, a continuing series

I have written in the past about how the typical treatment of debt levels in the business cycle tends to treat it as purely a demand phenomenon - that risk-seeking investors seek out debt in order to leverage their dangerous investments.

But, as with most things financial, there is a supply and a demand side.  And, if we think broadly about the two types of ownership - equity and debt - from a saver's point of view, debt is actually a sign of risk aversion.  Risk averse savers invest in debt.  Risk seeking savers invest in equity.

There are a lot of moving parts here.  For instance, in an economy saddled with systemic risks, debt levels will tend to be lower because the debt itself is considered riskier.  This may be part of the reason for the global finance trade, where developing market savers seek out developed economy debt for safety while developed economy firms invest in developing economy equity.

But, in the US economy, which generally is stable and which is built on the long term establishment of institutional trust, debt is generally associated with risk aversion.  And, corporate debt isn't particularly sensitive to interest rates.  Firms are price takers when it comes to risk premiums.  When interest rates are low, this is a sign of risk aversion, which means that when interest rates are low, equity investors aren't particularly interested in leveraging up.  This is also true cross-sectionally.  It is the least risky firms that tend to carry the most debt.

Here is a graph of corporate debt (credit market liabilities issued by non-financial firms) as a proportion of operating profit ("operating surplus" as defined by the BEA).  That's the blue line.  Then, the bar chart superimposed on that is a measure of the trailing 12 month change in non-financial operating surplus.

What we see here is that, in the aggregate economy, firms tend to want to settle at a debt level of about 4x to 4.5x operating income.  To the extent that things like growth expectations affect the enterprise value of firms, that generally accrues to equity values.  There appears to be a pretty stable limit to debt/income levels in equilibrium.

Now, what we see, since the mid-1980s, is debt/income that settles in around 4-4.5 during expansions, and then it shoots up above that level during contractions.  The reason debt/income shoots up is because these are unexpected income shocks.

Debt levels don't rise because risk-seeking savers get careless as an expansion ages.  Risk-seeking savers bid up equities, like they did in the late 1990s.  Debt levels rise because firms are reeling from a contraction.  And, once the contraction subsides, firms retrench until debt levels settle back at 4-4.5x.

Where in the world did we get the idea that we have to draw back the economy because firms will get too risky and borrow too much?  What data is that story based on?  It looks to me like we are actually creating the leverage problem, not solving one.

What would happen if instead of engineering contractions in corporate profits, we tried to engineer a continuation of positive profit growth?  What if that actually led to rising interest rates for savers, improved negotiating power for laborers, solid returns to pensions, and robust tax revenues?  Recently, profits have not been great, and leverage has increased as profits have declined.  And, a reason the Fed is giving for tightening is to prevent some sort of push in wage inflation...

1 comment:

  1. "What would happen if instead of engineering contractions in corporate profits, we tried to engineer a continuation of positive profit growth? What if that actually led to rising interest rates for savers, improved negotiating power for laborers, solid returns to pensions, and robust tax revenues? Recently, profits have not been great, and leverage has increased as profits have declined. And, a reason the Fed is giving for tightening is to prevent some sort of push in wage inflation…"--Kevin Erdmann

    From your lips to G-d's ears.

    I guess there is a Hyman Minsky concern somewhere, but then if we believe in EMH, or even just in markets, then Minsky is a no-show.

    It is strange there is a whole tribe of monetary commentators who basically hold that institutional investors go bananas whenever interest rates are too low…

    ReplyDelete