How does corporate debt fuel market bubbles?

Welcome to Finance and Fury, The Furious Friday Edition

Today – want to look at how much Corporate debt has been fuelling the top end of the share markets growth – signs that if liquidity is withdrawn, companies and markets collapse

 

Last FF ep – went through the flow-on consequences of low-interest-rate environment and QE policies - Free money

Today - brings us full circle to the reality of the past decade: that any credit binge will always be popular because while the benefits of leverage come today, the costs of bad debt come tomorrow. Personally – Think about your personal situation for a minute – you could take a massive car loan for a new BMW, or go on a holiday on your CC = but the pain of repaying this comes later – the other option of saving over years to afford a new car or round the world trip doesn’t give you that lifestyle boost today Improving a business or learning a skill requires dedication and hard work - but Monetary “stimulus” – which is essentially credit - offers a siren-like, promise of effortless prosperity yet ignores the reality that credit binges always sow the seeds of their future destruction – in this case to the economy As an example – look back to September 15 last year - the normally low overnight repo lending rate soared to an astonishing 10% annualized rate - A shocked Fed felt compelled to “do something,” which these days invariably means adding still further to the pool of loanable funds Size of the add (via the Fed’s T-bill purchases and expansion of its repo facility) has been nearly a cool half-trillion, well over half of the total size of the Fed’s pre-crisis balance sheet. The Fed justified adding this tidal wave of liquidity notwithstanding its characterization that what happened was a mere “technical” glitch in the repo market. Technical, really? Why then have they just announced more liquidity to be injected again at about $100bn to avoid another spike in the rates? A practical take is that the market is talking to the best and brightest minds in central banking, and the Fed doesn’t like what it’s hearing: the repo market wants to clear at rates above the Fed’s IOER fiat rate, which, if allowed to do so, would likely invert the front-end of the yield curve. Inverting curves sounds a bit too much like ending a credit binge, leading to recession, and so the Fed’s response function is to “veto” (Latin for “I forbid”) the market’s signal. The Fed continues to continue to pretend the cycle need never end. But markets will be what they must be, and investors must face the consequences of the last decade’s credit binge – again in the future but not today

 

There are two subjects that the mainstream media seems specifically determined to avoid discussing these days when it comes to the economy: The first is the problem of falling global demand for goods and services; they absolutely refuse to acknowledge the fact that demand is going stagnant and will conjure all kinds of rationalizations to distract from the issue. End of Globalisation period – this is a whole other topic – might cover on Monday as part of coronavirus scare The other subject – which is part of today's topic - the debt bubble, the corporate debt bubble in particular. These two factors alone guarantee a massive shock to the modern global economy But a reduction in globalisation isn’t the major immediate concern - corporate debt is the key pillar of the false economy - as the fundamentals are starting to catch up to the fantasy of where a lot of large-cap companies are currently trading at Starting to see a pattern – that the share market is no longer an indicator of the health of the real economy One reason is that corporate stock buybacks have been the single most vital mechanism for inflation in the prices for markets – where companies buy their own stocks back off the market - often using cash borrowed from each other and from the Federal Reserve/Central banks – All done to reduce the number of shares on the market and artificially boost the value of the remaining shares – boosts the EPS as well – if earnings of a company look the same as yesterday, but now you have 10% less shares – then the EPS just rose by 10% - process is essentially legal manipulation of equities, and to be sure, it has been effective so far at keeping markets elevated. But similar to financing lifestyle to look like you are rich and prosperous through a credit card – the problem is that these same corporations are taking on more and more debt through and also interest payments in order to maintain the façade Over the period of a decade, corporate debt has skyrocketed back to levels not seen since 2007, just before the credit crisis. The official corporate debt load in the US now stands at over $10 trillion, and that's not even counting derivatives exposure – According to the BIS - amount of derivatives still held by corporations stands at around $544 trillion in notional value (theoretical value), while the current market value is only around $10 trillion.  This is a massive discrepancy that can only lead to disaster – as it carries massive counterparty risks Also – Derivatives through their function also act as a quasi-leverage system – pay a premium now for the nominal value at a later date In terms of corporate debt-to-GDP - the credit cycle peak has spiked beyond any other peak in the past 40 years Borrowing always has consequences - Even if central banks were to intervene on a level similar to TARP – troubled asset relief program - saturated markets with $16 trillion in liquidity – today – the amount of cash needed is so immense and the economic returns so muted that such measures are ultimately a waste of time The Federal Reserve fuelled this bubble, and now there is no stopping it's demise. Though, they're behaviour and minimal response to the problem suggests that they have no intention of stopping it anyway. Looking historically – 1991 – just before a crash – was at 43%, then dropped to 38%, 2001 – was at 45% then dropped to 39%, 2008 – was at 45% and dropped to 40% - Now at 48% - at the high water mark But Currently, stock buybacks may be set to decline this year – not out of want - but need - have to quit, because the amount of debt they are accumulating is outpacing their falling profits - US Corporate profits peaked in the 3rd Quarter of 2018 and have been in decline ever since But thanks to buybacks - The Price-to-Earnings ratio as well as the Price-to-Sales ratio are now well above their historic peak during the dot-com bubble, meaning, stocks have never been more overvalued compared to the profits that corporations are actually bringing in The Fed has been putting effort into keeping the market strong – as the markets have been used as a proxy to real economy – as they used to be – but since central banking involvement – not so much Some companies, like Apple and Warren Buffet's Berkshire Hathaway, are holding extensive cash reserves, but most do not. Also, the level of cash reserves held by certain top corporations suggests they know something is on the horizon. Why hold piles of cash when the stock market is a “sure thing”? Unless the debt bubble is about to collapse and cash will be needed to absorb the damage? If this year is the year in which buybacks crumble – wouldn’t come as a surprise - Corporate profits degraded over 2019 and the slide is set to continue this year - This means profits are not going to come to the rescue and stave off the explosion of the debt structure These loans are now coming due, and the Fed has indicated it plans to tighten liquidity once again next month while returning to balance sheet cuts – but at the same time The Fed will have to institute a full QE program on the level of the TARP bailouts and cut interest rates to zero in order to end the constant repo liquidity threat and kick the can for a couple more years – without this these loans are coming due at a positive rate For now - central banks' intervention has achieved little except keeping stocks at all-time highs. The rest of the economy is in disarray – limited economic growth – despite the amount of money being pushed into the financial system The real economy will start to drag down the markets – but the big question is always one of timing. 

 

The Counter-argument The best counter-argument is that there is plenty of liquidity out there. Central banks are pumping the world full of money which is what has driven stock market valuations to current levels It is a good argument – and if they continue – then markets may go up further - It is also an argument that has a binary outcome - Market liquidity is a mind trick. If the market believes in the power of central banks, then stock markets can continue to rise – but how much faith will the market and the investments within continue to have with Central banks? But with lowering company earnings - the faith in central banks may disappear once negative earnings appear and the extreme corporate debt levels are tinder waiting for a spark Earnings growth is negligible. Valuations are more expensive than they have been since the tech bubble or pre-GFC This episode is just a counter to the last minute irrational exuberance It's hard to imagine a scenario in which there are no major shocks to the financial structure for the rest of the year - with the corporate system tapped out and no longer able to act as a support for the bubble, the fundamentals will start to take over again. Geopolitical events will also have a more visible effect. A whole year without a pandemic threat like the coronavirus going global? For those who listened to the complexity theory series – the basin of attraction is on a knife-edge – doesn’t take much for it to snap back like a rubber band

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Growth Index over time

 

Debt-to-GDP Percentage over time - United States