Quiet Shifts in Corporate Debt May Explain This Year’s Big Economic Surprise

The resilience of US growth, earnings and markets has been the big surprise of 2023. Stephen Dover, Head of Franklin Templeton Institute, opines on the factors at play—and whether they will last.

This article was originally published in Barron’s on August 29, 2023.

The resilience of US growth, earnings and markets has been the big surprise of 2023. Following more than a year of aggressive Federal Reserve (Fed) rate hikes, few would have believed at the beginning of this year that the United States would avoid a recession, see an upswing in US corporate earnings expectations, and enjoy a strong rebound of major equity indexes.

While many explanations have been offered to explain these phenomena, one important factor has been generally overlooked—US private sector debt. Over the past 15 years, US household and corporate sector indebtedness has changed significantly and in ways that make the economy, profits and equity valuations less sensitive to monetary policy than at any time in over a generation.

We will focus on the corporate debt story here. But we must note that household borrowing habits have also changed in important ways since the global financial crisis (GFC). Total household debt, as a share of gross domestic product (GDP), has fallen by nearly a third since 2008. Credit standards have tightened, with fewer at-risk households able to borrow or borrow as much. And, importantly, mortgage borrowing has reverted to conventional 30-year fixed rate mortgages and away from floating rate or adjustable-rate mortgages. As a result, the lags between the Fed’s short-rate hikes and debt servicing costs in the household sector have lengthened.

Those factors alone help explain why the US economy and consumer spending have held up better than many thought they would at the onset of 2023. A strong labor market, underpinned by post-COVID re-hiring, shortages of able-bodied workers, and fiscal stimulus have also contributed significantly to the resilience of demand.

But for economists, policymakers and investors, there has been another interesting debt development underway: the absence of any discernable impact of rising interest rates on corporate profitability. That outcome deserves closer attention, because it has important implications for growth, profits and equity as well as credit market outcomes.