Key Takeaways
- The Financial Fragility Indicator (FFI) has worsened to its highest level since the global financial crisis, crossing the zero line--the historical average--in the third quarter, to 0.71 from -1.21 in first-quarter 2022. With aggressive policy normalization and a recession expected, financial conditions are likely to weaken further this year.
- For the U.S. nonfinancial corporate sector, the FFI jumped by more than 5x in the third quarter to 1.02--over one standard deviation from its mean and its highest reading since second-quarter 2019. The increase in financial fragility was led by both higher leverage and liquidity risk, primarily as short-term debt increased and market value declined.
- The FFI of U.S. households shot up to 0.40 in the third quarter of 2022 from -0.32 in the previous quarter. While balance sheets weakened from extremely solid readings through the first half of 2022, the household FFI remains near its historical average and is still considered to be in healthy territory.
The Financial Fragility Indicator (FFI) worsened to its highest level since the global financial crisis amid aggressive monetary policy tightening as the Federal Reserve tries to tame inflation. The FFI crossed the zero line--the historical average--in the third quarter, to 0.71 from -1.21 in first-quarter 2022 (see chart 1) as financial conditions worsened over the past six months. With aggressive policy normalization, financial conditions are likely to weaken further as concerns about the U.S. economy heading for a shallow recession in the first half of 2023 grow.
Both the household sector and the nonfinancial corporate sector experienced deteriorating financial conditions. The nonfinancial corporate sector crossed the one standard deviation threshold (the upper bound) into vulnerability territory (see chart 2). By type of risks, leverage and liquidity risks for both nonfinancial corporates and households rose, leading to a decline in net wealth.
Chart 1
Nonfinancial Corporates
The FFI of the U.S. nonfinancial corporate sector jumped by more than 5x in the third quarter to 1.02--near the 10-year high of 1.16 seen in first-quarter 2019 (was 0.16 in the previous quarter). The increase in financial fragility was led by both higher leverage and liquidity risk, primarily as short-term debt (that must be refinanced at potentially higher interest rates) increased and market value declined as the stock market turned bearish. At the same time, businesses are increasingly less able to pass through costs to consumers, as people increasing shop for value and trade down for lower-priced substitutes. Business demand for workers remains hot. But an expected weakening in economic activity in 2023 will cool the jobs market next year.
Chart 2
Leverage risk
Leverage indicators in the third quarter of 2022 worsened from the prior quarter, in terms of their annual growth rates. The exception was the interest coverage ratio, which increased to 9.7%, better than its high at the end of March 2022 of 8.8%. On increased leverage, net debt to EBIT worsened to 2.66x--its highest level since the summer of 2020--from 2.31x, while the debt-to-asset ratio remained relatively flat at 22.9% from the preceding quarter.
Liquidity risk
Liquidity conditions for nonfinancial corporate entities worsened in the third quarter, with the ratio of liquid assets to short-term debt falling to 72.3% (its lowest rate in 10 years) from 77.8% in the previous quarter. U.S. corporate entities are increasingly facing liquidity risk as interest rates are rising. Meanwhile, short-term debt as a share of total debt in the third quarter widened to 32.9% from 32.5% in the previous quarter.
Other composite and indirect indicators
The return-to-asset ratio inched down in the third quarter to 3.6% from 3.8%, further indicating rising financial vulnerabilities of the U.S. nonfinancial corporate sector. The market-to-book ratio also fell, to 1.25 from 1.32 in the second quarter of 2022, pushing up the FFI as the average net worth of corporates declined.
Households
The FFI of U.S. households shot up to 0.40 in the third quarter of 2022 from -0.32 in the previous quarter, crossing over its historical average (see chart 3). Leverage, liquidity, and net worth showed signs of deterioration, on average. While balance sheets have weakened from solid readings through the first half of 2022, the household FFI remains near its historical average and is still considered to be in healthy territory. This is helped by a still-tight jobs market with year-over-year wage gains, in nominal terms, twice the historical average of 2.5%.
Chart 3
Leverage risk
Leverage risk largely remained steady from the previous quarter but was higher than the same period of last year. The debt-to-disposable personal income ratio remained flat at 1.03 compared to the second quarter but was up 5.2% year over year. Meanwhile, the charge-off rate on consumer loans continues to climb, reaching 1.3% in the third quarter. The loan-to-value ratio remained relatively flat at 27.2% in the third quarter (the lowest since 1986).
That said, the debt service ratio rose to 9.7% in the third quarter from 9.6% in the second. The debt service ratio is up from its all-time low of 8.5% in first-quarter 2021, though it's in line with its 9.7% rate in first-quarter 2020. Overall household debt increased by $351 billion to $16.51 trillion (i.e., a 2.2% increase from the previous quarter), with mortgage loans accounting for over 80% of the total debt. Mortgage debt in the third quarter reached $282 billion, about the same as in second-quarter 2021 and the highest quarterly increase in mortgage liabilities since the third quarter of 2003. Since the pandemic began in the first quarter of 2020, over $2.11 trillion in mortgage loans were issued.
Liquidity risk
Liquidity worsened further as the ratio of liquid assets to short-term liabilities declined significantly to 8.83 in the third quarter of 2022 from 9.2 in the previous quarter. Short-term debt as a percentage of total debt inched up to 33.2%, from 33.1% in the preceding quarter.
Wealth effect
The household net worth-to-debt ratio declined in 2022--to 7.45 at the end of September 2022 from 8.17 at the end of 2021. Households took a major hit from the slide in stock prices as the equity market fell further into bear market territory. On the other hand, we continue to see an uptick in debt levels. While household net wealth has weakened, net worth to debt is still robust, indicating healthy balance sheet conditions despite sliding net worth.
Moreover, average cumulative household savings are around $1.3 trillion above the pre-pandemic 2019 amount. Together with a still-healthy jobs market keeping wages elevated, households have a cushion of significant excess savings that is only slowly being depleted. However, cumulative household savings are well below the $2.5 trillion peak in 2021, when hefty fiscal stimulus, along with fewer places to spend during the pandemic, supported saving.
More On The Indicator
The Financial Fragility Indicator is a weighted average of indicators that reflect the financial fragility of corporates and households from different perspectives. We use principal component analysis to construct the indicator. The Financial Fragility Indicator includes not only the individual indicators at present but also their recent history to account for the possibility that financial risk may take time to mature and affect the economy. Zero represents sector financial vulnerability at historical average levels, positive values indicate higher vulnerability compared with history, and negative values indicate lower-than-historical average vulnerability. For more information on how we construct the Financial Fragility Indicator, see "The Financial Fragility Of U.S. Households And Businesses Hit A Decade Low In The First Quarter," published July 30, 2021.
The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.
This report does not constitute a rating action.
| U.S. Chief Economist: | Beth Ann Bovino, New York + 1 (212) 438 1652; bethann.bovino@spglobal.com |
| Research Contributor: | Debabrata Das, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai |
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