Source: Platinum Portfolios Quarterly Newsletter (Q1 2024)
On 16 March 2022 the US Federal Reserve Chair, Je-rome Powell, approved the first interest rate hike in more than three years at that time. The Federal Re-serve also announced that many hikes would follow to try and address the soaring inflation. After the first rate hike it was followed by 10 subsequent hikes, conclud-ing in July 2023. The federal rate is now standing at 5.25% – 5.5% which makes it much more expensive to borrow money than it has been in the past 17 years. A higher federal funds rate means banks’ borrowing costs are greater. They pass this on to consumers in the form of higher interest rates on things like auto loans, mortgages and credit card debt.
While the impact of these interest rate hikes on individual consumers is important to monitor, there’s an underlying threat that extends to companies that have been taking advantage of the prolonged period of low rates. Many corporations borrowed excessively during this time, and the rise in interest rates is now placing pressure on their financial positions. One key metric to watch is the net debt to EBITDA ratio, which provides insight into how many years it would take a company to pay off its debt. Generally, a ratio below 2 suggests a healthy ability to service debt, but when this ratio exceeds 3, it raises concerns about the company’s ability to manage its debt burden ef-fectively. Alarmingly, the S&P 500 had a net debt to EBITDA ratio of 1.46 in 2001, but this figure has been steadily climbing and now sits at 2.6 at the close of 2023. As rates remain high, certain companies may struggle to service their debt, potentially leading to reductions in dividends and share buybacks, posing risks to investors’ portfolios.
The debt issue isn’t isolated to the corporate world; household debt has also surged, reaching record levels by the end of 2023. Consumer spending saw a marked increase during this period, but it soon became evident that this rise was driven primarily by consumer debt. Credit card debt, in particular, rose by an alarming 46% since the be-ginning of 2021, with roughly 8.5% of outstanding credit card debt being at least one month overdue. Delinquency rates on credit card and auto loans continue to creep up and are now nearing record highs. These worrying trends have been unfolding over several years, prompting the critical question: how much longer can these debt levels continue to rise unchecked?
While it remains unclear how long this pattern will persist or if the US government will intervene if a financial crisis emerges, it’s vital for us as fund managers to remain vigilant. We have a responsibility to anticipate and manage the risks associated with this environment of rising debt levels. Despite the potential for interest rate cuts later this year, debt and interest rates will still remain elevated compared to recent historical levels. This should serve as a wake-up call for everyone to recognize the hidden threat posed by soaring debt levels.
While the economy may appear to be humming along on the surface, the reality is that there is a significant un-dercurrent of risk due to the ever-increasing debt burden at both the corporate and household levels. It’s essential as fund managers to be proactive in recognizing and addressing these risks to safeguard the future financial sta-bility of our clients. Let’s ensure we keep this rising debt on our radar and take necessary actions to mitigate its po-tential impacts.