Turning Japanese

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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)

The L-shaped recovery

Photo by BRUNO CERVERA on Unsplash

Investors blindsided by the virus shouldn’t compound their problems by thinking that things will immediately return to normal once it passes.

It’s hard to predict the outcome of unprecedented events because, by definition, they’ve never happened before and handicapping them is nearly impossible. The models used by scientists to justify a complete shutdown of the global economy to mitigate the spread of the coronavirus may turn out to be off by a factor of ten, or more. It’s not meant as an indictment of them but an acknowledgment that like most investors trying to navigate the markets, they haven’t done this before either. At least not on this scale.

For that same reason, we should be skeptical of forecasts of a swift rebound once the virus passes. Just like how faulty data skews computer models, those calls seem to grossly underestimate the potential long-term damage to consumer confidence, supply chains, and the rejection of globalism in general. Garbage in, garbage out.

We were warning all of last year that markets were in an increasingly precarious position. See “Stall Speed“, “Tipping Point” and “Powell Plays for Time“. A decade of excessive monetary stimulus provided by the major central banks since the last recession in 2009 had all but destroyed the price discovery function of markets and dulled investors to signs of trouble. Record equity prices as a result of the Fed’s guiding hand and abundant liquidity obscured unsustainable debt burdens, slowing economic growth, declining corporate earnings and deteriorating credit quality. Many believed, and likely still do, in the Fed’s ability to extend the business cycle forever and revive the 11-year old bull market. To us the contradiction is nuts but as the old saying goes, the markets can stay irrational longer than you can stay solvent.

The virus exposed some serious vulnerabilities of the global economy, most notably the level of debt. As a result, we think that the economic adjustment to new societal norms and changes in consumption behaviors will take longer to play out than most of us can conceive.

Government officials and other commentators who are pushing a narrative of a V-shaped economic recovery are wrong on two basic assumptions.

1) It ignores the global debt dynamic, and the possibility that this event represented a tipping point long in the making. An unintended consequence of quantitative easing programs was companies taking advantage of cheap money to buy back their own stock and pay dividends rather than investing in their businesses. That’s now over, especially for any entity accepting federal assistance. And it should be.

Despite low rates and lots of government cash on offer, corporations will be forced to de-leverage their balance sheets to align with a new economic reality, which will come at the expense of capital spending, investment, and employment. Borrowing and refinancing costs could also rise as many companies suffer rating downgrades or find access to funds restricted by wary lenders. Businesses operating on thin margins, even large corporations, may not survive. If they do they are likely to run mean and lean for years to come rather than re-staff their employee ranks.

2) The claim of pent-up demand is ludicrous. Consumers are in shock. If you weren’t worried about your job before, you sure as hell are now. Just because your job might have survived the initial wave of layoffs it doesn’t mean it won’t get eliminated as the fallout ripples through the economy. Free government handouts will keep the lights on but don’t fool yourself into thinking that it is stimulative.

Rent payments that got waived in April are going to have to be paid in full in May or June, in addition to the current amount due. Credit card interest will continue to accrue. Most mortgages have been securitized, making it impossible to extend the terms and simply add missed payments onto the back end of the loan. Sure, you can defer several months’ payments but the bank is going to want all that back in a lump sum sometime this summer. And if you skipped eating out ten times or missed three haircuts while on lockdown, you’re not going to then go order ten meals when the curfew is lifted.

To steal a term from former Secretary of Defense Donald Rumsfeld, there are still too many unknown unknowns right now. To conclude that things will return to pre-virus normal is fantasy.

Many of us grew up hearing stories about the Great Depression of the 1930s. Unemployment then peaked at around 25%, and it affected spending habits for two generations. People hoarded, they saved. Like my parents and their parents before them, they never let go of that mindset.

Governments and central banks are literally throwing money at both the markets and at citizens alike in an effort to stop the bleeding, but for the reasons stated above it may not be enough. Don’t confuse liquidity with solvency. The Fed might be able to address the former, but for many, the latter is still very much a risk.

One big positive for the economy is the resilience of the American consumer. The labor force is more flexible, means of communication and transportation more efficient and capital markets more dynamic than it was last century. Technology helps society to adapt to changing conditions almost instantaneously. In large measures, people can now work and shop from home. The shutdown may actually open our eyes to better and more efficient ways of conducting our day-to-day lives.

While nobody could have forecast the COVID-19 virus, at this time last year we recommended being long of the U.S. dollar and front-end treasuries as a play on slowing global growth. We still like those positions but would urge readers to consider adding physical gold to their portfolios and use this rebound in stocks to reduce risk exposure. In the months and years ahead, many countries will be making moves to weaken their currencies (i.e. printing money) to stimulate their economies and regain an advantage in international trade. Gold is the flip-side of the depreciating fiat money coin.

So when William Devane appears on your TV urging you to buy precious metals as a hedge against “unstable governments printing paper money”, know that he may be on to something.

US Dollar Index (DXY)
US 2yr Treasury Yield

Jaws 2

Diverging paths of the economy and the market continues to be a study in contradictions

Photo by Viktor Talashuk on Unsplash

In the weeks since our last comment the major central banks, led by the Fed, have ridden in hard to try and extend the life of what is already the oldest economic expansion in history. A confluence of declining corporate earnings forecasts, weakening industrial and retail activity, and persistent funding shortfalls in dollar-based securities markets has forced the Fed to administer CPR on the financial system. Despite the outwardly calm appearance, the Fed is very nervous, literally throwing money at both the economy and the markets in an effort to prevent a downturn in global growth from metastasizing into another financial crisis. Massive levels of debt and leverage encouraged by profligate central bank policies over the past decade now mean that the normal cycles of the economy…and the inevitable periods of weakness…cannot be allowed to play out naturally without risking a complete meltdown in the financial markets. (See BBBe Careful).

In October alone the Fed restarted their balance sheet expansion, ramped the daily overnight repo financing allocation and cut rates for the third time in four months. It’s a veritable fire hose of liquidity that pumps between $60 and $100 billion per month into the marketplace. It’s also a dead giveaway that everything is not fine. Former Dallas Fed advisor Danielle DiMartino-Booth aptly described the state of play as the Fed trying to “suppress the unknown, that at its best is credit volatility and at its worst systemic risk.”

So far the deluge of liquidity, at least initially, seems to be having the desired effect. Like every other time in the last eleven years that the Fed has fired up another round of quantitative easing, regardless of prevailing economic trends, record highs in the S&P were all but certain to follow. This time is no different. And almost as if the third consecutive quarterly decline in year-on-year corporate earnings don’t matter. The title of our recent piece ‘Liquidity Trumps Fundamentals‘ speaks for itself.

Don’t be fooled by Jay Powell’s attempt at downplaying the need for future rate cuts and reassuring investors that the expansion still has legs. See https://on.wsj.com/2pTHtfE Having to hit the panic button after nearly a decade of policy stimulus is definitely not a position in which anyone on the board of governors thought they would find themselves. It’s becoming abundantly clear that without a major reset in asset prices and a restructuring of the role of the central banks in the markets, rates will never be normalized. The Fed is headed into a policy cul-de-sac from which there is no exit. Like an addict, they’ve hooked the markets on easy money. Make no mistake, the minute stocks stumble, rate cuts will be back on the table. As much as they’d like everyone to believe it, this is no simple mid-cycle policy adjustment. It’s a one way street toward zero interest rates. If there’s a lesson from the past year, it’s that the economy remains vulnerable and that the bull market in equities and credit is not self-sustaining without the Fed’s foot firmly on the gas.

Presumably, corporate CEOs get this. These are the guys making decisions on hiring and capital investment. The latest survey of CEO confidence is shockingly bad and contrasts starkly with optimism among consumers (see charts below). Visually, the surveys are very similar to the chart that became popular several months ago comparing opposing trends in equities and bond yields. Coined with the name “Jaws” it illustrated two major financial benchmarks projecting distinctly different economic outcomes. (See “Jaws” Could Take a Bite Out of Markets). Which indicator is ultimately proven right (bonds or stocks) remains an open question. The two charts below from The Conference Board on confidence reveals a similar contradiction. History shows two things: 1) CEO confidence leads consumer confidence and 2) a sharp deterioration in CEO confidence has immediately preceded each of the last five recessions (the gray shaded areas). But as with the original Jaws chart, which side is ultimately right and how these normally correlated, but currently divergent, trends snap back into line is yet unknown.

Our preference is to bet on the side of history. The heavy dose of hopium from coordinated central bank intervention driving stocks and bond yields higher in the past few weeks will fade in time. It’s another sugar high. We have been long the front end U.S. rate complex for all of 2019 and still see this sector as the most effective play on slowing global growth. The Fed has a trigger finger with respect to cutting rates. Be patient, but the widespread position flush underway in the bond market this week is an excellent opportunity to reload those long positions between now and year-end.

Jaws 2. CEO and Consumer Confidence telling different stories. Shaded areas are recessions. Courtesy Quill Intelligence

Or, expressed another way:

Record discrepancy between corporate and consumer confidence. Shaded areas are recessions. Courtesy Deutsche Bank Global Research
Dec 2021 Eurodollar future. Approaching support.

Fed Rate Cut: Too Little, Too Late

Strong dollar poses risks for reluctant policymakers

Photo by Colin Watts on Unsplash

August 4th, 2019

The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.   

As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.

In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.

Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.

Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.

The US dollar, breaking out.