Where is the earnings recession?

• An earnings recession was all the experts could agree on
• How companies are playing central bankers for fools
• Ernest Hemingway’s personal financial advice

It’s earnings season for many of the world’s largest corporations, with a slew of results being posted this week. Yes, alongside fighting the Culture Wars with shareholders’ funds, companies do still try and make money on the side too.

So far, the traditional upside surprises are within what you’d expect, with only the healthcare sector disappointing investors.

But it’s the dog that didn’t bark which interests us today…

Going into the current global economic slowdown, there was one thing all experts could agree on: an earnings recession was coming.

Company profits would fall as the economic slowdown, spiralling producer price inflation – such as energy costs – and soaring interest rates took their toll on companies’ financial statements.

Sure enough, we’ve had recessions and poor economic growth in many places. But corporate profits are doing so well that companies are getting blamed for causing inflation.

What went wrong… or should I say right?

The earnings recession was supposed to be especially severe this particular economic cycle because so many companies had borrowed so much money so cheaply during the pandemic years. With many of those companies struggling to pay their interest bills as it was, earning them the name of “zombie companies”, the interest rate hiking cycle was sure to kill the remaining undead.

Even for those that survived their interest bill, higher interest bills would mean lower profits, and those would mean lower share prices, all else equal.

But the earnings recession just hasn’t shown up in the data, despite a record-breaking interest rate hiking cycle and double-digit producer price inflation. Stocks have rallied well into the economic slowdown and rate hiking cycle instead of falling.

Today, we look into part of the explanation…

Companies borrowed rather large amounts of money at rather generous interest rates during the pandemic. About $12 trillion according to the International Monetary Fund. Some companies even had negative yields on their bonds! And remember, central banks bought some corporate bonds directly themselves.

So everyone loaded up on debt when it was cheap. Then interest rates went up. And now everyone is stuffed.

Simple, right?

Wrong…

The underlying issue is the duration of the borrowing (a bit like the term of the loan) and what was done with the money.

Governments and companies usually don’t borrow money at variable rates. They issue bonds at fixed rates. So, if interest rates rise or fall, that doesn’t impact their cost of existing debt.

Of course, rates did rise, and fast. Companies, sitting on vast reserves of very cheaply borrowed money, invested much of the cash at the new higher rates. It is now earning them a lot more interest than their cost of borrowing when they borrowed it.

That is why their net interest expense – how much interest they earn on their money less how much they pay on their debt – isn’t turning into a major headache. In fact, it’s turning into a major tailwind for profits.

It’s all a bit like those borrowers who are still on the fixed period of their mortgage from 2021. If they have a savings account, that account may now be earning them more interest than their mortgage costs them. Thus, they’d be turning a profit by having borrowed money from the bank and then deposited it at the very same bank!

And so we have the strange phenomenon that interest rates have spiked rapidly, but companies’ net interest expense has actually fallen in the US, and rapidly so. Companies are earning decent interest on their money and paying little on the old borrowings that raised the money in the first place.

The music only stops on this game when companies and governments must refinance their debt. That is, when they must borrow money in order to pay off their bonds that have come due and demand repayment.

Then, suddenly, the interest expense ratchets up to a much higher level because the new borrowing will be at the higher rates. It’ll be just like a mortgage that tips into its variable rate at a much higher level.

According to Societe Generale’s researcher Albert Edwards, the phenomenon I’ve described has been “adding 5% to profits over the last year instead of deducting 10%+ from profits” as it would in a normal recession and interest hiking cycle, when companies don’t sit on large cash balances.

The deep irony here is that interest rates are not working to slow down the economy as they should. They’re boosting corporate profits instead… for now.

That’s for companies. What about governments?

Well, unlike companies, governments don’t have vast piles of cash sitting around to earn interest on. So they’re not able to spin central bank interest rate hikes for a profit. Indeed, in many cases, central banks’ losses due to their monetary policy is causing governments a fiscal problem too. But let’s leave that for another day.

Governments borrow so much money so often that they constantly have bonds maturing. That means they constantly have to borrow more to repay some of their old debts. This in turn means that higher interest rates are passed on to the government’s budget earlier than for most borrowers in the economy, but in a slower fashion over longer periods of time.

We are beginning to see governments’ interest expense spiking as interest rates have caused a rather large fiscal problem for many of them. As ever, the UK leads the world in this particular problem according to the Financial Times:

The UK is on track to incur the highest debt interest costs in the developed world this year as persistently high inflation and an unusually large proportion of government bonds linked to price rises damage the public finances.

The Treasury will spend £110bn on debt interest in 2023, according to a forecast by Fitch. At 10.4 per cent of total government revenue, that would be the highest level of any high-income country — the first time the UK has topped the data set that goes back to 1995 […]

The Peter G. Peterson Foundation summed up the numbers for the US:

The Congressional Budget Office (CBO) projects that interest payments will total $663 billion in fiscal year 2023 and rise rapidly throughout the next decade — climbing from $745 billion in 2024 to $1.4 trillion in 2033.

In total, net interest payments will total nearly $10.6 trillion over the next decade. Relative to the size of the economy, interest will rise from 2.7 percent of GDP in fiscal year 2024 to 3.7 percent in 2033. The previous high for interest relative to GDP in the post-World War II era was 3.2 percent in 1991 — that ratio would now be exceeded in 2029.

So, if the projections are correct, about 3.7% of US GDP will be interest payments on US government debt in ten years’ time…

It’s worth noting that the economy grows at about 3%, so a 3.7% interest bill drag is not good news in the long term. The interest bill will leave the welfare and defence budgets behind within the decade too…

Again, the irony here is that higher interest rates are not having their intended effect. Interest expense has become such a large part of government budgets that it’s taking on a life of its own.

Instead of raising the cost of borrowing and thereby slowing the economy, higher interest rates are causing governments to borrow ever more money in order to repay their existing debts. And each time they do, their interest bill rises rapidly because they borrow at the new higher rates in order to repay debts that were borrowed at lower rates.

Thus, higher rates are actually pumping more money into the economy, not less, via the government budget. Higher rates could become inflationary rather than reining in inflation.

When Ernest Hemingway explained that he went bankrupt “Gradually, and then suddenly,” he may have been referring to the same idea. The “gradual” part refers to the moment when you borrow money to repay old debts. The “suddenly” moment is when the interest cost on your debt eats up an impossible share of your income.

We’re transitioning from one to the other by borrowing to repay ever higher rates of interest.

Whether it’s the stock market, the government budget or inflation, look out!

Until next time,

Nick Hubble
Editor, Fortune & Freedom