The Weekend Edition is pulled from the daily Stansberry Digest.
It doesn't seem possible that 2020 could get any worse...
In addition to a global pandemic that has upended our daily lives, leaving millions of folks without jobs, we've seen rioters destroy parts of several U.S. cities... a near-record number of hurricanes... devastating wildfires along the West Coast... "murder hornets"... and more.
But with all that's going on, I bet you haven't heard about a looming disaster in China. The world's most populated country is enduring its worst flooding in decades...
It hasn't been this bad since 1998, when government estimates showed that floodwaters impacted around one-fifth of the country's population of more than 1 billion. Back then, more than 3,000 people died, and the economic damage totaled more than $20 billion.
This past summer, China had been deluged with a prolonged period of heavy rain.
As a result, the world's largest dam is now in danger of collapsing...
The Three Gorges Dam in central China sits on the Yangtze River. Stretching 3,900 miles, the Yangtze is the third-longest river in the world and China's most important waterway.
The dam is five times bigger than the Hoover Dam in Nevada, spanning 7,700 feet with a height of more than 600 feet. It's also the world's largest hydroelectric power plant.
The reservoir behind the dam holds 42 billion tons of water... When the dam is full, there's so much water that its concentrated weight slows the Earth's rotation by 0.06 microseconds.
Upon completion in 2006, China's state-run media outlets boasted that it could withstand the worst flood in 10,000 years.
Now, just 14 years later, it's in jeopardy of being washed away...
Continued heavy rain has caused the Yangtze River to swell, with water levels recorded at 170 meters on Monday – 23.5 meters above the Three Gorges Dam's warning level. The enormous weight of the water behind the dam has already caused landslides along the reservoir.
In late July, the Chinese government acknowledged that the dam had "deformed slightly" from the flooding during the month. Operators maintain that the dam is still safe despite the defects... But the danger is not over.
Tens of millions of people live downstream from the dam along the Yangtze River, including the large populations in Wuhan and Shanghai. If the dam fails, hundreds of thousands of people will likely die... and millions more will probably see their homes washed away.
Now, I'm not a structural engineer. I can't tell you whether or not the Three Gorges Dam will ever collapse... or whether it's within years, weeks, or even days of a catastrophe. I certainly hope not. No one wants to see millions of people lose their homes or worse.
But I am an analyst who tracks what's going on with the credit markets. And as I read about the dangerous floodwaters rising at the Three Gorges Dam, it reminds me of how the COVID-19 pandemic is exacerbating our debt problem...
The COVID-19 pandemic is a lot like the continual storms in China this year, dumping pain on the economy...
Government and corporate debt levels are rising steadily, day after day... much like the waters along the Yangtze River. With most businesses' sales down significantly due to the shutdowns, they're forced to borrow just to pay the bills.
The longer COVID-19 weighs down the world's economies... the higher the debt "floodwaters." Like the floodwaters at the Three Gorges Dam, this rising debt is putting massive pressure on companies' capital structures.
Not every company will be able to withstand the pressure. Many "debt dams" will break. Here's what I mean...
You can think of a "debt dam" as a divider between a company's debt and equity...
The debt dam separates a company's debtholders from its stockholders.
Think of the company's stockholders as the folks who live just down the river from the dam. The company's debtholders live above the dam, near the reservoir. The flow of water in the river is the capital that the company needs to flourish.
The debt dam brings a lot of benefits...
First, it keeps the stockholders from flooding by giving the large amounts of capital a safe place to accumulate. In other words, when companies want to raise cash, they can use their reservoir of debt. By using debt to raise the capital, stockholders aren't flooded with new shares of stock every time the company needs cash.
Second, the dam generates power for stockholders. In that regard, you can think of debt like a power generator for corporate earnings. It allows companies to produce much higher profits on a given amount of equity investment.
The problem, of course – as with most things in life – is excess...
Too much of a good thing becomes dangerous... Extra leverage brings added risk. When the sun stops shining, the debt doesn't go away. It still must be repaid.
That's exactly the problem facing many companies today. They were already levered to the hilt even before the COVID-19 pandemic began... U.S. corporate debt was at an all-time high, both in nominal dollars and as a percentage of gross domestic product.
And now with the economic downturn caused by the COVID-19 pandemic, corporate debt piles are growing dangerously larger.
Like the Chinese government officials operating the Three Gorges Dam amid prolonged periods of heavy rain, companies hope the COVID-19 "storm" passes quickly. But immense pressure is building. Their "debt dams" are fast approaching the point of failure...
And the thing is, many will collapse.
When a "debt dam" breaks, it completely wipes out all equity...
When a company goes bankrupt, the equity instantly becomes worthless. The debtholders take over everything. And when companies emerge from bankruptcy at some point down the road, they only do so with new owners.
So far, we've eclipsed 36.5 million reported cases of COVID-19 globally, including around 7.5 million in the U.S. Unfortunately, the current economic storm isn't likely to subside anytime soon. The spread of the virus is likely to accelerate during the winter flu season...
The longer we're dealing with the threat of COVID-19, the more "debt dams" are in danger of collapsing. That's why I believe a vast wave of bankruptcies is approaching...
In fact, we're already starting to see this play out across corporate America...
According to credit-ratings agency Standard & Poor's ("S&P"), 120 U.S. companies defaulted on their debt so far this year... including 61 in the second quarter. That's the highest number of quarterly defaults since 80 companies defaulted in the second quarter of 2009.
The list of companies filing for bankruptcy so far in 2020 includes 112-year-old gas-engine maker Briggs & Stratton... gym operator 24 Hour Fitness... vitamin and supplement retailer GNC... Ascena Retail, owner of women's apparel stores Ann Taylor, Loft, and Lane Bryant... and Lord & Taylor, the country's oldest department store.
And unfortunately, this is just the beginning. Things will get much worse...
We can see what's coming by looking at the number of companies whose credit has been downgraded. Downgrades are an early warning sign... They always come before defaults.
So far this year, S&P has downgraded the credit of roughly 2,100 companies. That's already more than any year on record. Take a look...
To me, 2020 looks a lot like 2008, the year before the default rate peaked in the last financial crisis. But 2020 is already much worse. And we still have three more months to go.
It only takes one small part of a dam to fail for the entire structure to collapse... In the same way, it's only a matter of time before the credit market collapses.
There's another reason to expect a vast wave of bankruptcies...
You see, banks across the country are once again tightening credit. They're making it more difficult for companies to borrow money.
And tighter credit conditions often precede a soaring default rate. Take a look...
This is important...
Companies with weak credit rely on banks to "roll over" their debt when it comes due. These borrowers depend on new loans to pay off their existing debt as it matures. They will have nowhere to turn when banks tighten. Without access to new credit, they'll simply die.
A trend of tightening credit will hasten the wave of bankruptcies.
I believe we're still in the early phases of a slow-motion disaster...
We're just seeing the initial cracks in the side of the dam today. The real damage hasn't even been done yet. The numbers are about to get much, much bigger...
The U.S. high-yield default rate is about 6% today. That means only 6% of all corporate borrowers have defaulted over the past year.
But S&P is forecasting that the high-yield default rate will more than double to 12.5% by next June. That would be the highest default rate since the Great Depression in 1932.
S&P's current "pessimistic" forecast projects the default rate to reach 15.5%. That means another 250 to 300 companies could go bankrupt over the next year. So as you can see, the storms will likely get much worse.
And yet, investors don't seem worried at all about what's happening...
After plunging more than 30% in about a month earlier this year, the benchmark S&P 500 Index charged to new highs – and is trending higher again after last month's pullback. The picture is the same for the tech-heavy Nasdaq Composite Index.
Debt investors don't seem to be concerned with the approaching storm clouds, either...
The high-yield credit spread – the difference between the average yield of so-called "junk" bonds and the yield of similar-duration U.S. Treasury notes – tells us how much risk that investors are pricing in bonds at any given time. When the spread is low, investors aren't concerned at all about defaults. When it's high, they're worried about getting paid back.
The spread has fallen to around 500 basis points ("bps") today. It's once again below its long-term average of around 600 bps, after rising to more than 1,000 bps in late March... a few weeks after the World Health Organization declared COVID-19 a global pandemic.
The lack of worry among investors is concerning...
The Federal Reserve won't bail out every company. Its efforts to help most businesses so far were only done to instill confidence in the credit markets. The Fed has prevented credit from drying up... But it's still just extending the day of reckoning for many companies.
The excessive debt balances can only continue to rise for so long. Eventually – and in most cases, suddenly – companies collapse. Unsuspecting investors will be wiped out.
I've shown you the warning signs... record levels of corporate debt... record numbers of credit downgrades... and a rising number of banks tightening credit.
It's only a matter of time before many more debt dams break. Consider yourself warned.
Regards,
Mike DiBiase
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