Insolvencies herald the bears

The accompanying chart plots in simple terms what most of us would point to intuitively: the correlation between distressed corporate debt levels and the performance of London’s equity markets. Based on notices in the London Gazette, the number of companies falling into administration across England and Wales increased by 4.3 per cent in 2017, although the rate of activity slowed during the final quarter of the year.

The rate of debt delinquencies is symptomatic, bound up in the corporate and consumer debt cycles, with the UK disproportionately exposed to the latter – and we’re in a distinct down-leg right now. Readers would have noticed a rising number of post-Christmas profit warnings and store closures, with consumer-facing businesses, most notably some high-profile restaurant chains, feeling the heat. My colleague Algy Hall thinks this is largely reflective of overcapacity in the market, rather than a substantive fall-away in aggregate demand. If that’s indeed the case, then last year’s contraction may be a harbinger of something a little more severe.

You can see that when the lines cross in the chart, things can get ugly very quickly – and you could be forgiven for thinking they’re starting to coalesce. If so, it could herald the arrival of the bears. But properly prepared for, bear markets can be more of an advantage than a disadvantage – many investors will be savouring the prospect of picking up some of their favourite stocks at unusually low prices.

Unfortunately, any accompanying economic slowdown increases the chances of listed firms falling foul of their financing obligations. The level of corporate insolvencies is reflected in all the major UK equity indices, but it’s much easier to delineate the relationship through markets such as Aim, whose constituents may have reduced access to senior debt, an inefficient secondary market in their shares, or perhaps both.

Aim has been subject to a high rate of attrition down through the years, a feature of the market exacerbated by some questionable decisions on the listing front. But a recent study by UHY Hacker Young points to a reduction in Aim departures due to financial mismanagement leading to insolvency; nine exited for this reason in 2017, compared with 24 in the previous 12 months. A statistical blip perhaps, or does it suggest, as some analysts have posited, that you get a better class of company on London’s junior market nowadays? There is a certain Darwinian logic to the claim, and if you look at the accompanying liquidity metrics for some of the most heavily traded Aim stocks, they look to be better insulated than many of their main board rivals.