Turning Japanese

Photo by Nicki Eliza Schinow on Unsplash

The Fed’s response to COVID will zombify corporate America for a generation

Written June 21, 2020

In “The L-Shaped Recovery“, we predicted that a combination of demand destruction, job market uncertainty, rising debt, and a shift in consumer behavior would hinder the economy from achieving a rapid recovery from the COVID pandemic.

Since that writing, the Fed has taken the unprecedented step of intervening directly in support of the credit markets, producing a spectacular V-shaped rebound in the financial markets. But as we all know, the market is not the economy.

The economic template that the current public health crisis is most often compared to is the Great Depression of the 1930s, but a more instructive precedent for what the future holds might be that of Japan, which is still trying to shake off the effects of the financial market bubble that popped in 1989.

To put the excesses of 1980s Japan in context, it was said that the 280 acres of land within the walls of the Imperial Palace in central Tokyo was worth more than the entire state of California. At the time, this became the benchmark against which all other insane real estate and lending valuations were linked. When it inevitably crashed, Japan, Inc. tried borrowing their way out of trouble. More than 30 years later, and after racking up an eye-watering debt-to-GDP ratio of 279%, they’re still trying to find a way out.

In Japan, bankruptcy is not seen as a financial tool deployed to clear the decks of bad debt but rather as a cultural stain, one of humiliation and loss of face. So corporate Japan, and the country itself, stumbles onward like a zombie, burdened by mountains of legacy debt, unable to reap the benefits of innovation that leaner balance sheets would enable. This interminable trap is so ubiquitous that it even has its own name: Japanification.

Unfortunately, the Fed is headed down a similar path. Not only by backstopping the credit markets but by actively pushing prices higher, the Fed has allowed almost every corporation access to cheap money. It may be necessary, but just like the never-ending policy of quantitative easing destroyed the price discovery function in the equity markets, the unintended consequence of credit intervention is doing the same to the bond market. Normally where good corporate governance is rewarded and bad decisions are punished, everybody now gets a trophy.

In my day job as an editor for a financial news service, I spend a large portion of my time reading press releases from companies tapping into an almost unlimited supply of liquidity in the credit markets, with most of it going to refinance revolving bank debt incurred during the pandemic. Borrowing is literally exploding.

While this widespread refi effort is tactically beneficial in the near term to bridge the gap in cash flow created by the virus lockdown, the long term risk is that it will allow bad capacity to remain on the books, keeping unproductive companies alive and leaving little room for innovation and for fresh entities to thrive.

Corporate America was already running record levels of debt and leverage before the pandemic hit. Half of the investment-grade bond market is precariously rated BBB, just one notch above junk. Wide-scale bankruptcies and credit downgrades are indeed a systemic threat in a weakened economy, and it is forcing the Fed’s hand to prevent the entire system from snowballing downhill and out of control. But, like Japan, the unintended consequence of today’s policies will be a debt burden that will take years, if not decades, to climb out from under.

In a note to clients last week, Bridgewater Associates’ Ray Dalio warned of a “lost decade” for the equity markets as profit margins get squeezed by debt servicing costs. See here https://bloom.bg/3hMBVtC.

We tend to agree and would use this recent rebound in financial markets to reduce risk exposure while sticking with core long positions in the US dollar, short-term treasuries, and gold.

Debt explosion (courtesy Federal reserve bank of St. Louis)
Sharp rise in unproductive debt (courtesy Deutsche Bank)

Stall Speed

The Fed’s foot is on the gas but the economy is losing altitude

Photo by Richard R Schünemann on Unsplash

Investors have gone all-in on the bet that the Fed and its central banking colleagues abroad will be successful in turning around a slowing global economy. The melt-up in the S&P since early last month is like Wall Street’s version of pushing your chips to the middle of the table. It’s not really surprising seeing that in October the Fed, the Bank of Japan, the European Central Bank and the People’s Bank of China all expanded their balance sheets for the first time in more than two years, giving the markets a massive shot of adrenaline.

As far as actual economic results, there aren’t many green shoots to be found around the world. Last week the U.S. reported unimpressive Industrial Production and Retail Sales numbers, dragging the Atlanta Fed’s widely watched U.S. GDP tracking model down to just a 0.4% pace for the current quarter. See https://bit.ly/2r3ifvH. China also had poor production and sales results. Japan’s economy is growing at only 0.2% and Germany just barely avoided recession with a 0.1% growth rate. Not an encouraging picture.

Given all the monetary firepower that the central banks have deployed over the past decade, they don’t have much to show for it. But the thing that sticks out to us, and the real threat to the global economy is pictured in the chart below. Despite the appearance of policy success as reflected by rising equity prices, corporate bond defaults are actually increasing. If the policy was working, that wouldn’t be happening.

The Fed can’t stop the deterioration in credit. Chart courtesy S&P.

We have written extensively on the danger that a deteriorating credit sector poses for policymakers. (See Time to BBBe Careful). Recently the IMF raised a red flag on the state of U.S. corporate risk-taking and declining leveraged loan quality. See https://bit.ly/35m9DPL. They ominously predict that in the event of an economic downturn “corporate debt at risk of default would rise to $19 trillion, or nearly 40 percent of the total debt in eight major economies.” Yes, that’s trillion with a ‘T’. The IMF also noted that “surges in financial risk-taking usually precede economic downturns.

To say that this is potentially a massive problem is the understatement of the year. The market, in this case the corporate bond market, has officially become the economy. An explosion in global debt pushed by extreme central bank policies since the 2008 recession is a burden that steals from future growth, meaning that a simple economic slowdown carries not just cyclical but systemic risks of default. It is the Fed’s greatest nightmare. And they can’t allow it to happen.

Rather than seeing the Fed’s actions for what they are, an act of disaster prevention for the credit markets, many investors are taking the dynamic of falling rates as a cue to pile into riskier trades. There’s an unshakable faith that the Fed will allow no harm to come to them. It seems like a misreading of macro conditions to us, and an unwise strategy after a 10 year-long bull run, but for now the market obviously disagrees.

It’s gotten so crazy that even one of the world’s largest mutual fund companies is urging baby-boomers to lay off the stocks. According to Fidelity Investments, more than one-third of boomers (born 1944-1964, and entering retirement) have a greater than 70% allocation to equities, and one-in-ten were invested entirely in stocks. See https://bloom.bg/2pxjvXu. This has disaster written all over it when the market eventually turns.

We’ve long said that some enormous trading opportunities will present themselves at that point when the markets lose faith in the Fed and realize that current policies will fail to stop the rot. We’re not there yet, but it’s getting close. In the meantime take the market rally as a gift to raise cash, and stay long the front end rate complex.