A $10 trillion debt burden coming due one day could hit the stock market and Amazon, UBS proposes

Key Points
  • UBS strategist Francois Trahan points out U.S. corporate debt has surged by 50% over the past decade and now stands near $10 trillion. 
  • Such a jump in corporate debt would be more worrisome had it not been for the steep drop in yields, he says.
  • But these concerns could be front and center in 2020 as slowing economic activity and a potential fall in corporate earnings could lead to debt downgrades for companies such as Amazon, 3M and Walmart.
Traders on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

This decade's surge in corporate debt could pressure stocks in 2020 as corporate earnings slow to a crawl, hurting the ability of companies to timely repay that debt and keep the solid credit ratings that allow them to borrow so cheaply, according to a theory laid out by UBS strategist Francois Trahan.

Many Wall Street strategists share the concern about the ballooning corporate debt load but few sound as worried as Trahan. Most put it as a footnote in their 2020 outlook reports. The issue is, as Trahan points out, is that credit issues usually don't matter to the equity market unless the economy is in a slowing or contracting phase.

In a Tuesday note, Trahan said that U.S. corporate debt has surged by 50% since 2009 and now stands at nearly $10 trillion. Such a jump in corporate debt would be more worrisome had it not been for the steady economic recovery and steep drop in yields, he said. Since 2010, yields on Baa-rated corporate bonds have fallen to around 3.9% from more than 6.3%.

IIF discusses the rise in corporate debt and global leverage

However, the impact could be felt as early as next year as slowing economic activity and a potential fall in corporate earnings lead to debt downgrades for some of the biggest companies in the world, including Amazon, 3M and Walmart. Debt downgrades could mean these companies would have to roll over their debt — half of which matures in the next five-to-six years — at a much higher rate, putting pressure on their shares and the broader stock market, he proposes.

"Leaving aside our biases for markets and the economy, LEIs of credit markets point to a deterioration of ratings throughout 2020," Trahan said.

Trahan pointed to the Institute for Supply Management's new orders index as a key leading indicator, noting it has been in a downtrend for about six months. He also noted the index has been below 50 over the past four months. A reading below 50 signals contraction.

This decline in new orders could foreshadow a drop in the S&P 500's average credit rating, which has risen on a year-over-year basis. Trahan notes that measure of economic activity leads the stock benchmark's average credit rating by six months.

"Moreover, interest rates argue that this decline in the ISM is not likely over, suggesting that this risk could possibly last throughout all of 2020," the strategist said.

Rates fell throughout 2019 as the Federal Reserve pivoted away from the hiking cycle it set off during the previous year. The central bank cut the U.S. overnight rate three times this year after four rate hikes in 2018.

All of this takes place at a time when earnings expectations are just above flat. However, if those expectations decline and turn negative, it could amplify debt downgrades for S&P 500 companies and in turn, hit their stock prices, he proposes.

Amazon, 3M and Walmart at risk

Trahan noted Amazon, 3M and Walmart are among the S&P 500 companies that are at risk of receiving a debt downgrade in 2020. The strategist made this determination using a model that accounts for company size, short and long-term capital turnover, profit margins and long-term liquidity.

Based on that model, Amazon is at risk of seeing its S&P credit rating to BB, the highest junk-bond grade from AA. Meanwhile, 3M could see its credit rating fall from AA to BBB along with Walmart.

Trahan has an S&P 500 target of 3,000 for 2020, which is tied for the lowest one with Morgan Stanley's Mike Wilson. That represents a 6% drop from Tuesday's close of 3,192.52.

To be sure, Trahan expected the broad index to end 2019 at 2,500, which is more than 21% below current levels.

Subscribe to CNBC on YouTube.