The key to this cycle’s resilience

We believe the most important – and underappreciated – feature of this cycle is the strength of private sector balance sheets. While there is plenty of handwringing over growing public debt, which is a justified concern over the long term, the flipside has been a sharp reduction in private sector leverage – which matters most right now. This backdrop has made the economy and financial markets far more resilient to shocks, reducing the probability of worst-case outcomes. While downside risks remain, structural private sector balance sheet strength keeps us viewing the cycle and markets with a glass-half-full outlook.

Before COVID, both US household and non-financial corporate leverage declined significantly. Post-GFC, households rebuilt balance sheets, reducing debt relative to income substantially, bringing overall leverage to multi-decade lows. Corporates, supported by strong earnings and low rates, refinanced and improved debt sustainability even as they invested and grew.

Post-COVID, deleveraging continued for different reasons. Households benefited from fiscal support and surging asset prices, which boosted net worth and lowered debt-to-asset ratios. Corporates initially borrowed to weather the crisis but later deleveraged on the back of strong earnings and equity financing, particularly in tech. Regulatory changes and tighter credit conditions reinforced this trend.

Exhibit 1: US private sector balance sheets are very healthy 

US private sector balance sheets

Healthy private sector leverage is not just a US story. Since the Global Financial Crisis, household debt ratios have steadily declined, with a second wave of deleveraging following COVID. In both the euro area and the UK, household debt relative to GDP has fallen, driven by stronger nominal growth and reduced borrowing amid higher interest rates. Corporate debt has followed a similar path, as firms have responded to tighter financial conditions by paying down debt rather than taking on new leverage. Delinquency rates remain low, and the financial system appears well equipped to manage current credit risks.

There are pockets of concern in both the US and globally – such as the significant growth of non-bank financial intermediaries (NBFIs), consumer subprime credit and lending in commercial real estate. Japan’s private sector has gone against the global trend, with leverage rising since COVID as interest rates have remained arguably too low for the country’s reflationary dynamics.

Nevertheless, on the whole, recent years have seen a decline in economy-wide debt-relative-to-GDP across most G7 households and companies, even as (and in part, because) the era of ultra-low rates has passed.

Exhibit 2: Households have been deleveraging since COVID

Credit to households* (% of GDP)

*BIS credit to households and non-profit institutions serving households.

Exhibit 3: Companies have also been reducing leverage since COVID

Credit to non-financial corporations (% of GDP)

We'd argue that low leverage has been the key factor in keeping this cycle resilient to some severe shocks. In our view, it was central to keeping the economy afloat despite sharp central bank tightening cycles in 2022-23. Likewise, it enabled the US and global economies to survive the Liberation Day shock, and push forward even as effective tariff rates have risen not very far from Liberation Day levels. More recently, we think it is core to understanding ongoing resilience in consumption despite a slowing labor market. And while there have been areas of concern in credit of late, the overall low private sector leverage suggests to us that recent developments are unlikely to be systemic. Consistent with this thesis, delinquencies actually look to be peaking.

Exhibit 4: US consumer delinquency rates appear to be peaking

US consumber deliquency rates

We certainly do not mean to suggest that just because private sector actors have de-levered, the environment is riskless. The labor market is clearly soft, and whenever the unemployment rate is rising, there is always danger of a non-linear break. We also recognize too that much of the strength in household (and corporate) balance sheets is skewed towards the wealthy – a sharp fall in asset prices, for whatever reason, could have negative confidence effects. Moreover, we are cognizant that while AI capex, which has been a meaningful driver of both economic activity and the market, has been largely cash-financed, it is set to become increasingly debt financed.

Nevertheless, we do think starting points matter, and as much as balance sheets could weaken on the margin, we believe they would still remain exceptionally strong. In the face of a shock, the median household or business should not have to retrench the way it has ahead of most prior recessions. If there ever was a structural economic backdrop that justified higher multiples and tighter credit spreads, this is one of them.

The flipside to the private market deleveraging observed since the GFC has been a marked leveraging of the public, or government, balance sheets. The two trends are linked as some of the policies that facilitated private market balance sheet health – lower taxes, strong COVID stimulus – actively worsened the budgetary outlook for many of the world’s economies. Although we’d argue that public debt does not present the same near-term risk to end the expansion, many advanced economy debt trajectories are ultimately unsustainable and have the potential to put upward pressure on interest rates over the medium to long term, potentially ‘crowding out’ private investment. Term premia on government bonds has risen, especially on ultra-long-term debt, as investors demand more yield to compensate for debt risk.

Still, it’s important to remember that US (and other reserve-currency) issuers borrow in their own currency from a deep buyer base and stagger maturities, so only part of the debt reprices each year. If nominal growth stays in the same ballpark as borrowing costs and budgets tilt toward higher-return investments, we believe the burden will be manageable and there will be time to adjust. We think it’s important to watch three dials for sovereign stress – interest expense/GDP, auction demand and the longer-term inflation outlook. We are also keeping an eye on cross-asset correlations – persistent rises in US yields accompanied by a decline in the USD, as occurred periodically earlier this year, would be a warning sign. While we watch these developments, we still would argue that if the economy is operating at high debt loads, we’d rather it be governments shouldering the burden as opposed to private sector actors.

We remain overweight global equities amid healthy private sector balance sheets, strong earnings and Fed easing. We continue to prefer the US, Japan and EM – where we see the most positive earnings stories – relative to Europe. We see government bond yields at fair value, and think that high quality fixed income remains an important hedge should the economy weaken more than expected. After a strong run, we have reduced exposure to precious metals amid the spike in volatility, although we think gold plays a strategic role in portfolios as a real asset amid still sticky high inflation and growing government debts.

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