2016 Effects of Plunging Oil Prices, Debt Defaults, and Uncertainty in the Chinese Markets
More U.S. companies have defaulted on their debt in 2015 than issuers from any other country, S&P analysts wrote in a December 24, 2015 report.
The report noted that 111 companies worldwide had defaulted on their obligations, the highest total since 2009 when the figure hit 242 for the same period but that was a fallout from the Great Recession. U.S. oil and gas companies accounted for about a quarter of the 2015 defaults. After the U.S., companies from emerging markets were the second-largest defaulters, accounting for 23% of the pool.
Are we headed down the same road? I do believe we are headed for another recession in 2016. The culprit is declining oil prices placing stress on debt-dependent energy companies; the resulting high level of debt defaults; and uncertainty in Chinese markets.
Plummeting oil prices and speculation about how the Federal Reserve’s plan to tighten monetary policy would affect corporate borrowing costs has made companies more vulnerable according to the S&P report. “The current crop of U.S. speculative-grade issuers appears fragile, and particularly susceptible to any sudden, or unanticipated shock.”
Falling profits and increased borrowing at U.S. companies have been rattling debt markets, a sign the six-year-long economic recovery could be under threat. Credit-rating firms are downgrading more U.S. companies than at any other time since the financial crisis, and measures of debt relative to cash flow are rising. Analysts believe profits at large companies declined in the last quarter of 2015 for the second straight quarter, a first since 2009.
The market for riskier debt has become snarled, raising fears that companies could have trouble repaying their obligations following several years of record debt issuance, low corporate defaults and persistently low interest rates. Reflecting those concerns, investors are now demanding more yield to own corporate bonds relative to benchmark U.S. Treasury securities.
What about the Chinese effect? The fact is no one can count on China to provide accurate and reliable data. The national government routinely interferes with currency markets where China’s manipulation of the Yuan against the dollar has led to instability in Chinese securities markets. Add to that a slowdown when compared to past historical highs in GDP growth and we have to wonder whether China can control its markets sufficiently to generate continued economic growth at the 8% level. There is a crisis of confidence right now in Chinese markets. Much of it is due to a perceived lack of ethics of Chinese government officials in acting transparently and exercising due care.
I believe the Chinese markets will continue to greatly influence U.S. equities going forward. I also believe there is a moral hazard element to these markets. Chinese state-owned entities know the government will bail them out if need be so they might not play it as close to the vest in these economic turbulent times for the Chinese as otherwise.
Back to the problems in U.S. markets, in August and September, 2015, Moody’s Investors Service issued 108 credit-rating downgrades for U.S. nonfinancial companies, compared with just 40 upgrades. That’s the most downgrades in a two-month period since May and June 2009, the tail end of the last U.S. recession.
Standard & Poor’s Ratings Services downgraded U.S. companies 297 times in the first nine months of 2015, the most downgrades since 2009, compared with just 172 upgrades. Meanwhile, the trailing 12-month default rate on lower-rated U.S. corporate bonds was 2.5% in September, up from 1.4% in July of last year, according to S&P. About a third of the downgrades targeted oil and gas companies or firms in other commodity-linked industries, following a plunge in oil prices in the second half of 2014.
Bond prices have suffered. A Sprint bond maturing in 2025 fell from about 96 cents on the dollar to about 77 cents in September 2015, after Moody’s downgraded the company. A 2024 McDonald’s bond dropped from about 104 cents in April 2015 to about 99 cents in June 2015 after an S&P downgrade in May.
The fact is we’re seeing more widespread weakness across more industry sectors in the U.S. It’s become broader than just the commodity story.
Another cause for concern: the earnings outlook is starting to dim, as slower growth in China and low commodity prices begin to hit firms’ revenue. In the third quarter of 2015, earnings for S&P 500 companies were expected to decline 5.1% over the same quarter in 2014, according to data as of September 30 from FactSet. That follows an earnings decline of 0.7% in the second quarter compared with the year ago period.
Worries about companies’ financial health have pushed the difference in yield—called the spread—between corporate bonds and ultrasafe U.S. Treasury’s to its highest level in more than three years, according to Barclays data. A bigger spread means investors want more interest relative to Treasury’s to compensate them for the added risk of buying corporate bonds.
The U.S. is entering unchartered waters where the global economy slows, serious questions persist about China, and uncertainty where oil prices might go. Finally, will the Fed continue to raise interest rates thereby increasing the cost to borrow for U.S. businesses?
Add to the mix the increasingly volatile political environment in the Middle East and Northern Africa, and the continuing spread of radical groups like ISIS, and the mantra for 2016 should be to batten down the hatches.
Blog posted by Dr. Steven Mintz, aka Ethics Sage, on January 26, 2016. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.workplaceethicsadvice.com.