It's true that an effect can become a cause. And the themes behind the headlines are alternately causal and symptomatic of excessive leverage, but all of this is playing out against a moribund interest rate environment. Though nominally positive for stock market valuations, evidence is mounting that low interest rates are only good news for equities over a limited time frame.
The reasons why EU bosses are clamouring for a concerted fiscal stimulus are clear enough, but their pleas mightn’t necessarily square with provisions under the European Fiscal Compact and they certainly seem at odds with the warning given by Kristalina Georgieva, new managing director of the International Monetary Fund (IMF).
It’s not as though Ms Georgieva is fundamentally opposed to the idea of state intervention. After all, she previously served as vice-president of the European Commission. But her comments support the widely held view that monetary policy has reached its limits. In an ultra-low interest rate environment, there’s only so much that central banks can do, particularly given that public debt as a proportion of gross domestic product is running at an average of 85 per cent across the eurozone and at 94 per cent among Europe’s five largest economies.
And yet it’s ballooning debt (or more accurately, its underlying quality) in the private sector that has Ms Georgieva most concerned – and she may have a point. Analysis from the IMF shows that in the event of a global downturn corporate debt at risk of default would exceed levels seen before the global financial crisis.
Nowhere is this better illustrated than in the leveraged loan market, the size of which (est. $1.5 trillion collateralised) has more than doubled since the collapse of Lehman Brothers. Banks were forced to repair their balance sheets and provide increased capital buffers in the wake of the crisis, so institutional investors stepped in to provide corporate funding in their stead. This was made possible because central banks have been suppressing interest rates as a means of sustaining aggregate demand in the global economy.
A high proportion of the leveraged loan market is driven by private equity, whether in terms of M&A activity or in providing finance for start-ups, the latter traditionally the preserve of stock markets. The trouble is that a high proportion of the loans within the market are also free of covenant, and have increasingly been granted to companies that are more susceptible to credit downgrades when the economy tanks. As soon as default rates start to crank up, liquidity will be withdrawn from debt markets and many companies will be left high and dry.
The good news is that retail investors are unlikely to be on the hook, at least not directly, as collateralised loan obligations are not compliant with the Undertakings for Collective Investment in Transferable Securities (Ucits) directive, but there will obviously be a sting in the tail due to the level of institutional exposure – it’s very difficult to isolate losses nowadays.
So, by suppressing interest rates, central bankers may have provided a trigger for the next liquidity crisis. If Mark Carney is to be believed, a low interest rate environment has caused institutional investors to jettison stringent underwriting criteria as they cast around for high-yield options. Conversely, when interest rates are on the fly, you will eventually witness an improvement in the underlying quality of loan books, even if there is an increase in near-term delinquencies.
Low interest rates have provided further incentive for private equity firms to provide seed capital for start-ups with scalable business models, essentially taking the traditional place of the equity market, whereas late-stage private equity investors favour companies that already know how to generate a profit. The way that debt markets have evolved not only poses a threat to global economic stability, but with European stock exchange listings at a 10-year low, it is also depriving retail investors of a potentially high-growth stratum of the equity market. Eventually, cheap money is bad for everybody, including equity investors.
