For investors (and indeed for everyone else) 2020 has been a year where a crisis seems to be followed by yet an even bigger crisis. It started with growing political tensions threatening global trade, then came a global pandemic and an oil price crash which in turn led to one of the worst economic crises in history. And once it looked like things were slowly recovering, mass civil unrest ensued and we have just made it only halfway through the year.

Yet, despite all of this, the market so far has managed to remain surprisingly resilient, edging into a downturn but not it to a complete catastrophe like the one seen during the Great Depression. However, another impending crisis could well make it so, if not far worse. The number of ‘zombie’ companies is growing rapidly and if the situation does not improve, we could likely head towards a financial apocalypse.

What is a zombie company?

A zombie describes a being that should be technically dead yet is alive somehow. A zombie company is similar – one that is heavily in debt but earns just enough to continue operating and service its debt (but not pay it off). As one would expect, such companies, just barely managing to scarp by, are highly vulnerable to market disruptions. A small rise in interest rates, a decline in consumer spending, or a single poor quarterly performance could risk it becoming insolvent.

In a completely efficient market, zombie businesses wouldn’t exist, instead, being quickly replaced by more productive competitors. In real life, however, they remain animated by cheap credit, the access to which reduces pressure for these companies to invest in innovation and efficiency as well as shift the need for hard decisions well into the hazy future.

Often of massive size and thus, politically too costly for the government to be allowed to go insolvent, these uncompetitive corporate giants continue to lumber onward from repeated bailouts or generous bank loans. While this avoids a negative economic outcome in the short-term, in the long term, this leads to the crowding out of productive investment and the entry of newer, more innovative companies. This, in turn, can potentially lead to a steady decline in growth and eventually chronic stagnation as happened in the case of Japan.

What You as an Investor Should Be Worried?

Since the 2008 financial crisis, the number of zombie companies had more than doubled by 2017 accounting for roughly 16% of the components of the Russell 3000. The current economic crisis likely may have led to an even larger increase in the number of zombies. However, slower future expansion as a result of misallocation of capital into these companies isn’t the only aspect to worry on.

Because of their size, zombies can be contagious. If one fails, it can result in a panic and mass selloff of other zombie stocks, resulting in a chain reaction of more and more zombie companies going under, especially if banks, in response to the resulting chaos, starting raising their interest rates. As an increasing number of these companies default, banks and credit agencies who lent to them also suffer and risk illiquidity.

The resulting down spiral can significantly lower investor confidence and thus, even stocks of otherwise healthy companies decline as well.

Given the present uncertainties in the market today and the market rally following the first crash had since plummeted to levels seen in 2002 and 2008, it indicates another crash to be likely this summer. The longer the recession holds, the more likely it is for zombie companies to become insolvent and worsen the crisis further.

Moody’s analysts predict that the corporate default rate globally could climb to 6.8%, more than double the default rate witnessed in February 2020. Without the right intervention, such a scenario can potentially spiral into a prolonged period of economic contraction.

The Upside

While still vulnerable, markets today are far less affected by emotions than earlier times. Investment decisions today are made with smarter insights and the majority of trades today are managed by advanced A.I algorithms, invulnerable to irrational biases.

While this on-going recession is likely to become worse before a real recovery starts, the contagious effect of zombie companies may potentially not be as severe as we may expect. If anything, the current crisis reflects an opportunity for market corrections and pruning of inefficiencies, leading to a healthier and more resilient future economic landscape.