Updated: Aug 21
In this article we provide data driven insights to examine the prospects of a V-shaped recovery by analysing the rise in government and corporate debt, declining returns on capital and an emerging unemployment crisis. This is our third article in a four-part series examining the impact of the Covid-19 lockdown on businesses.
If this is the first time you have come across our risk analysis, we recommend reading our first two articles in this series to gain a holistic understanding of the key business and macroeconomic trends that will play an important role in defining the pace of an economic recovery.
Debt levels are rising to unsustainable levels
According to official statistics from the Institute of International Finance, gross debt across all sectors of the global economy is now 40% higher than the peak of the financial crisis in 2008. The total balance of government, corporate and household debt outstanding in the global economy is now estimated to be greater than USD $257.1 trillion, which translates to more than 3 times the value of global GDP (Gross Domestic Product) and 10 times the value of world trade. Data Sources: World Bank, World Trade Organisation.
For the first time since 1963, gross debt in the United Kingdom exceeds economic output. According to the Office of National Statistics (ONS), gross debt was £1.8 trillion at the end of March 2019, equivalent to 85.2% of GDP, which is 25.2% above the benchmark value of 60% set out in the Protocol on the Excessive Deficit Procedure. Latest published figures from the Office for Budget Responsibility's (OBR) show that borrowing in the current financial year (April 2020 to March 2021) is expected to be £298.4 billion, around five times the amount borrowed in the previous financial year. This brings the total balance of outstanding debt to £2.1 trillion.
With the total balance of debt growing by the day and the accelerating decline in GDP, which fell by 9.1% on average between June and July of this year, policy makers are in a very precarious position. The focus has shifted towards Covid-19, but we must not forget BREXIT and the complex legal, operational and financial challenges that come with it. In January 2020, the OBR estimated that the divorce bill with the EU is likely to cost the UK government £32.9 billion. It is important to note that this is an estimate of a bill that still needs to be settled.
In order for politicians and government to be realistic in their assessments of an accelerated economic recovery (V-shaped recovery), they need to consider the combined effects of the regional Covid-19 lockdowns and the inefficiencies that will manifest within our supply chains post-BREXIT. Given the accelerating increase in debt owed by the government, we need to ensure that every penny is spent wisely to fund improvements in economic productivity, job creation and socially diverse wealth creation. This is where investments in science, technology, engineering, mathematics and statistics will play a crucial role in creating evidence based solutions to deliver socially diverse economic wealth.
The rise in corporate debt and declining returns
In the first six months of this year 34% of businesses within our sample of 1,069 companies (incorporated in England and Wales) have taken on an additional £25 billion in debt. At the same time 53% of businesses have issued profit warnings with revenues estimated to be up to 45% lower compared to last year. Based on their interim financial data and profit warnings we are estimating the weighted average returns on equity to fall from 6.97% in 2019 to -5.82% by the end of 2020 with 80% confidence in our estimates. The confidence band in our estimates is illustrated in the graph below.
In our next article we will look at where companies went wrong with their financial strategies by using debt to financially engineer better returns on equity. We will also present solutions for more sustainable and resilient financial strategies.
The shock to earnings has created a widespread leverage problem
The dramatic drop in sales has had a significant impact on earnings, cash flow and leverage ratios. In the chart below, we have plotted the Net Debt to EBITDA ratios for all 1,069 companies in our sample. This ratio provides a measure of leverage that is commonly used by investors, lenders, credit insurers and credit rating agencies to evaluate the likelihood of a company defaulting on its debt. It tells us how many years it will take for a company to pay off its existing balance of debt using current reserves of cash and expected future earnings.
Net debt is calculated as short-term debt plus long-term debt minus cash and cash equivalents.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
While the detail in the graph might be hard to understand at first glance, the scale of the problem is easy to see. The red dots represent extremely leveraged companies that are at serious risk of becoming insolvent.
Interpreting the graph:
The blue dots to the left of your screen represent some of the least leveraged and most resilient companies within their sectors;
The purple dots in the middle of your screen represent highly leveraged companies;
The red dots to the right of your screen represent extremely leveraged companies that are at serious risk of becoming insolvent.
Generally speaking, if a company has a Net Debt to EBITDA ratio less than 5 then it’s considered a healthy company that’s less reliant on debt to fund its sales and earnings. Currently 42% of companies within our sample have a ratio less than 5. These companies are likely to become market leaders in the recovery because they have the freedom to innovate and adapt to new market conditions.
When a company has a Net Debt to EBITDA ratio greater than 5 then it is considered unhealthy because it depends on debt to fund sales and earnings. Currently 58% of companies have a Net Debt to EBITDA ratio greater than 5. These companies are likely to lose market share to healthier companies within their sector because they do not have the same freedom and flexibility to invest in growth opportunities. They will often have to stick to the same strategy that got them into their current position until they get approval from their debt holders to direct spending towards growth opportunities.
The ratio of net debt to earnings varies significantly between industries because each industry differs greatly in terms of the economic useful life of their assets as well as their operational efficiency and working capital requirements. This is why we presented the information with breakdowns by sector.
The unprecedented rise in leverage is creating an insolvency time-bomb where the knock-on effect will be a global unemployment crisis.
According to Euler Hermes, one of the largest trade credit insurers in the world, business insolvencies across the world are expected to increase by 35% over the next 18 months with the UK expected to see a 43% increase in insolvencies. This is 7% higher than the global average and the 6th largest increase amongst OECD economies. The unprecedented rise in leverage is creating an insolvency time-bomb where the knock-on effect will be a global unemployment crisis. The USA is expected to see the largest increase in insolvencies with 53% while China is expected to see a 40% increase.
The looming unemployment crisis
Based on data from Her Majesty’s Revenue and Customs (HMRC) there are 1.2 million companies claiming up to £34.7 billion in support from the Job Retention Scheme to retain the jobs of 9.6 million people. In addition there are 2.7 million self-employed professionals claiming £7.8 billion in support from the Self-Employment Income Support Scheme. In total, this is costing the government £42.5 billion to protect jobs in this highly distressed market.
The ONS reports the national unemployment rate during April 2020 to be 3.9% with the economic inactivity rate estimated to be 20.5%. The total number of weekly hours worked fell by 94.2 million hours compared to the same period last year. This represents the largest year-on-year decline in total weekly hours worked on record. The Claimant Count, which is an experimental statistic that seeks to measure the number of people claiming benefit because they are unemployed rose by 126% between March and May.
Based on the observed data and the fact that the Coronavirus Job Retention Scheme will expire at the end of October, we are expecting the unemployment rate to increase significantly over the next two years. With the added impact of BREXIT and the possibility of regional Covid-19 lockdowns we are predicting unemployment rates to reach between 5.8% and 14.2% over the next two years with 80% confidence in the predictions. If the highest estimate becomes a reality then the number of people unemployed in the United Kingdom will be the highest ever recorded in peacetime history.
For those that don’t believe this could become a reality, we urge you to look at the latest unemployment statistics in the USA, where the unemployment rate has surged to 14.7% with 23.1 million people unemployed. The USA now has the largest population of unemployed people in the world. In order to provide some context, Spain currently has the largest population of unemployed in Europe with 3.4 million people unemployed, which translates to an unemployment rate of 16.6% while France has the second highest population of unemployed people in Europe. Data Sources: OECD.
The reality is that there is no evidence of a ‘V-shaped’ recovery
The combination of evidence shows that there is no data to support a ‘V-shaped’ recovery and that any such claims are speculative. Given the added uncertainty of how the Covid-19 pandemic will evolve, the impact of future lockdown measures and the added complexity of BREXIT we would also be cautious of any predictions on how long a recovery will take. What we can say is that as new data is released and we start to fully understand the financial impact of lockdown measures we’ll be able to make more informed decisions on how businesses can change, adapt, survive and thrive.
What we are doing to help
We are helping private and public sector enterprises become more data driven and evidence based in their risk management and value creation strategies. We are helping companies avoid the the risk of becoming unsecured creditors of companies that are a high risk of becoming insolvent. We are also helping companies establish commercial relationships with companies that well positioned for growth in an economic recovery.
Our partners at Pivigo and Corndel are also helping businesses and public sector enterprises hire and train exceptional talent in data analytics, data science, and DevOps engineering to help them become more efficient and effective in analysing and processing big data.
We are working together to help clients make the right investment, risk management and cost optimisation decisions to protect jobs and maximise customer loyalty.
If you in you would like to find out how we can help you through these challenging times please get in touch.
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