Rory Smith

Market Commentary

For the week ending 19 October 2018
Report by Rory Smith
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Rory Smith

The Bank of England’s Financial Policy Committee, established in 2013, meets on a quarterly basis to monitor and take action to address, remove or reduce any systemic risks which could negatively impact the UK financial system. In recent meetings, the Committee has rightly been focused on the potential impact of Brexit. The minutes from the meeting on 03 October released this week – whilst also continuing to assess the Brexit risk, it highlighted a new risk to monitor; high levels of corporate debt, both in the US and the UK.

With regard to the US, the Committee noted that risks from the US corporate sector remain material, with gross debt having increased to “290% of annual earnings in the second quarter of 2018, close to 2007 levels”. Looser underwriting standards and the sharp increase in the stock of leveraged loans (now in “excess of $1trillion, relative to total corporate debt of circa $8trillion”) were identified as concerns. The extent to which the growth in leveraged loans (loans made to companies with existing high levels of debt) had parallels to the growth in the US subprime mortgage market ahead of the financial crisis in 2008 was also discussed, albeit there are important differences in how both were funded and also where the investment risk lies.

The Committee also assessed risks in the UK corporate sector at the meeting, and illustrated some concern about the rapid growth in leveraged lending, “which reached £38billion in 2017”. “A further £30billion has also been issued in 2018”. They estimate that the stock of debt outstanding in UK firms with a weak credit rating now stands at around 20% of total UK corporate sector debt. With banks retaining some exposure, the Committee will assess any implications for them in the 2018 stress test (results of which are due in December).

With interest rates globally remaining low relative to history, and global growth remaining buoyant, the ability of corporates to service this debt remains manageable, suggesting that this is not today’s problem. Nonetheless, with interest rates likely to rise in coming years it will be a risk to monitor. This particularly applies to leveraged loans, which have floating interest rates and, therefore, become more expensive to service as rates rise.

Outside of Brexit developments (or lack of), equity markets showed some signs of stabilising over the past week. This can in part be attributed to a good start to the US corporate earnings season, particularly from some of the large US banks. Further earnings released over the coming weeks will provide an insight into how corporates have been performing in a robust US economy, and is likely to influence how the US equity market performs heading into the mid-term elections in November.