Where the Skeletons, economically speaking, are laying down

Not yet buried, not even dead, firms are taking on more leveraged debt. In last week’s US print edition of the Economist, two articles make for chill reading.

The first article that heads the Finance and Economics section is titled, What Goes Up – The American economy. After emailing the current economic growth and the causes of it, the article suggests that things are likely to change. And this was written before last week’s midterms.

The theory is that the impact of the recent tax cuts will start to fade. Yes, this must be the case though there will surely be some residual net-increase in spending and change in behavior as a result. Tariffs are brought up as drag on demand; again this is likely true though there will also likely be some positives as local businesses, shielded from foreign imports, may seek new money to build up local services and supplies leading to some organic growth.

For me, the real risk is investment. Apparently that is falling again, after an uptick (due to tax breaks?). Investment, from primary R&D by central government through to capital investment by firms for plant and equipment, is really important. It is a key part of what will drive the next wave in productivity. We need to keep a watchful eye on all aspects of investment.

Finally the consumer is held up as the trump card, if growth is not to decline in the next year or so. Consumer spending is by far the largest component of US GDP. If spending here keeps up, business may yet increase again investment in response to growing demand.

With Congress split, the likelihood is that broad policy changes will not change- either the House won’t pass the Presidents policies or the President will veto, or the senate will not pass, anything significant the House desires. So my feeling is that growth may yet continue but slow down slightly, which would still be a good thing.

The second article is titled, Load Bearing. It reports that, “Authorities from the IMF to the Fed’s ex-boss are worrying about a booming corporate-credit market”. The credit being analyses here are leveraged loans. These loans are being chopped up into smaller trenches and sold to buyers with different risk appetites. Sound familiar?

The more important news is that we are talking of about $1.2 trillion dollars. Yes, that’s a big number and apparently it is twice as much as six years ago. Some of these loans are refinancing debt (about a 1/3, according to the article) and more is used to finance M&A.

These leveraged loans are attractive to some investors as they have offered good returns at a time when interest rates are low. This is a good example of unexpected and unintended consequences (and economic behavior) that has come about due to excessive periods of low or near-zero interest rates. Such rates mess with your funding approaches. Couple this with the principle, put up long ago, that lowering interest rates drives investment: not many IT or business transformation (i.e. large) projects I know about were conceived of simply because the Fed dropped rates.

The article explains how demand for these loans has led to lowering of standards, and a likely rise in defaults. Again, sound familiar?

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Politics and Spin Over Observation

The March 30th US print edition of the Wall Street Journal carried an Opinion piece titled, “Britain’s Monetary ‘Stimulus’ Has Fed the Pension Crisis“. The article highlights the plight of many firms whose pension funds are under water and how persistently low interest rates have crippled the chances to grow the returns on a number of investment vehicles. This is due to the widening gap between the value of assets and liabilities. The article happens to highlight this plight in conjunction with true fight in Britain over a venerable old British firm, GKN, who has impressively damaging pension liability any suitor needs to accommodate.

The real point of the article however is not really about GKN. It is that the Bank of England recently published a paper that argued its loose monetary policy and massive quantitative easing were in fact good for us. The argument of the report is that things would have been much worse, therefor whatever we have must be better. This is a strange argument. Much research has been published that correlated near-zero interest rates and QE with debt and credit price distortions, record-levels of M&A, record-levels of stock buy-backs, Stu only low capital investment levels, low productivity, and to top it all off, increased inequality. To be fair, if you didn’t watch the news and all those around you, the Bank of England report might be credible. If we had had a real crash, the pain might have been worse for a while, but the economy would have recovered as fast as other recessions due to the lack of credit and debit distortions.

The article closes on a useful warning and observations. Old firms with such large pension obligations and short-falls are suffering from a double-whammy. Such firms have to divert funds to stem the pension fund blessing that might otherwise have helped source the needed growth in the future to pay for those persons. Even if central banks had not kept rates so low for so long and stuff they investor-classes pockets with cheap money, such firms might still be in trouble-or anyway.

The Debt Chickens Are Coming Home to Roost

A story it today’s Us print edition of the financial times highlights a building ‘bubble’ of disquieting proportions. The article, ‘Britain’s Pizza Chain Boom Faces Debt Reckoning’, highlights how a large number of restaurant chains have been snapped up over recent years using debt. This might be by a private equity firm or a leveraged buy-out. In either and other cases, many acquisitions were executed using cheap debt which was facilitated by central bank policies such as near-zero interest rates and quantitative easing (QE), both of which massively distorted the price of corporate bonds and debt. Add to this public policy and pressure on banks to increase loans to help drive growth, you can see signs of a perfect storm.

The UK example is specific, but the problem is wide and applicable to most developed economies. The US has just come off a long-run marathon of high and record levels of corporate acquisitions, again much funded by cheap debt. There must be many organizations hanging by a thread, just waiting for interest rates to nudge up resulting in unsustainable debt burdens and interest payments. Unless growth drives the top-line of these businesses at a faster rate, the chances are many such firms will go to the wall.

This situation was created as an unintended consequence of near-zero interest rates for such a long time and massively price-distorting quantitative easing. Though most governments have ceased buying sovereign and corporate debt, the damage is done. Massive, trillion dollar, balance sheets at central banks need to be unwound in such a way as again, not upset the market. The act of creating the balance sheet did upset the market. In reducing their balance sheets, central banks will do it again.

And the sad part about all this, as it will play out? Smart investors with lots of money and a high risk-tolerance will hedge against such business failures and reap huge rewards. The rich investor-class will get richer, and the poor will just lose their jobs or otherwise miss out. Politicians will have a field day, calling out the failure of capitalism. Of course, it’s not a failure of capitalism since central banks and their policies are not part of any capitalist model: central bank operations are closer to a socialist model where the few take decisions to ‘help’ the many, as if they know better and how to help us.

Oh well, such is life. Just buckle down and wait the storm. The debt chickens will soon be home to roost. Maybe not by this Easter but expect them home by next year.

It Pays to Save

The UK was initially criticized for its austerity measures, employed at the height of the economic crisis that has slowly subsided now around the world. But some year’s later the UK was then lauded for being prescient. At the time, its economic growth was the fastest of any advanced economy. Things of course moved on – Brexit followed and even though the cloud did not fall in, the countries economic condition has slipped from front of the class to back. But that misses the point of this blog. The UK adopted austerity since that was the right thing to do – to reign in spending and support the natural economic rebalancing of price and supply. Other countries, when faced with economic challenges such as a slow-down or recession reach for the public sector check book.

This approach is known as Keynesian demand-management. The idea is simple, if not well understood as a simple idea from the practices namesake. When there is a shortfall in demand in the economy, the public sector increases spending to help fill the gap. Public spending, like any spending, creates knock-on effects whereby a dollar spent creates more than a dollar in ongoing spending. This simple idea became common thinking and the pain of the 1970s and 1980s were required for governments to learn that this approach has issues. First, Keynes had suggested that such spending should be temporary – since private sector spending was more efficient. However, even though Keynes noted this, it was left off the memo and his name became associated with “spend”, not “spend for a short while only”. As a result, governments spending increases were rarely ever temporary.

Secondly, and as we have seen in spades since the recent period of near-zero interest rates and QE, public sector spending crowds out private sector spending. The entire bond market has been distorted due to massive government intervention and spending. The whole pricing process has been disrupted. This is the same with the economy. As demand-management kicks in it forces normal public sector behavior to change. And so the economy is knocked off kilter even further.

So it was interesting to read some new material from the IMF that demonstrates that austerity is not the bad-boy all the politicians make out. The interesting article is called, Climbing out of Debt, and was published in the March edition of the IMF’s Finance and Development magazine. The actual data shows that countries that exploited tax-based austerity, versus reduced spending austerity, suffered deeper recessions. This is a kind of “devil you know” point in that first one has to prefer austerity over increased spending. Then, once austerity is accepted, one has to make a choice between increasing taxes (keeping public spending as-is) or reduced public spending. That is the key. Well worth reading to defend against the nay-sayers.

What Will Go Wrong in 2018?

James Mackintosh of the Wall Street Journal posts in today’s US print edition on “The 3 Things That Can Go Awry in 2018“. The article details three dynamics that, if played out as he suggests, could cause the global economy to trip in 2018. His summaries are good and compelling and, given our amazingly positive outlook today as 2017 comes to a close with all major nations growing at roughly the same time (an odd occurrence in its own right), they come at a good time to consider conservative actions against possible shifts next year.

The three are:

1. Monetary Tightening. The story here looks at Fed and central bank interest rate hikes. We all know that interest rate raises have started, at least in the UK and US, even though the EU remains firmly stuck taking that drug. Japan is taking it slow, even as its economy shows much signs of improved life – Japan will have to continue pushing rates up in 2018, just as the EU will have to follow the US’s lead. The problem with this item is that there are us a lot of debt out there – corporate debt, public debt and yes, some consumer debt. It is not the same kind of debt that was part of the run-up to the crash that put us where we are today, but for some firms and some governments its big risky debt. As an example, and tangentially related, another article in the WSJ reports on a few firms that are high in debt that will be financial impacted by Trump’s tax reform – see Tax Plan Downside for Dell, Others in Debt. A lot firms have issues debt in the last few years in response to QE and near zero interest rates. As rates increase, debt load and repayments will increase. If inflation were to join the party, it could be a messy time for a number of firms and governments.
2. China. This story has been used before since China has been the source of two recent periods where the US stock market (in fact the global stock market) fell by about 10%. As such, China’s management of its economy – shifting from a producer-based to consumer-based economy – is a major challenge. Debt remains a problem, and capital controls and currency exchange rates just add more menu items for Chinese leadership to wrestle with. Should China sneeze, so the saying goes, we would all fall could of a cold or something worse. Worse, there is no coordination between east and west – so we are somewhat at the behest of the Fed and People’s Bank of China – and we all hope they do the right thing. Of course, they will both do the right thing for their own constituents – or try to. Hence the lack of cooperation.
3. A Correlation Correction. This for me is the more interesting and most likely issue to blow up in 2018, and it is the least talked about in the press since it is not as well understood. Mr. Mackintosh states, “one reason investors hold bonds is to cushion losses in a stock-market downturn.” This approach has worked for quite a while, as prices have diverged short-term all the while converging over the long-term. The risk is that should inflation appear in 2018 the relationship between stocks and bonds may revert to how it was in the 1980s and early 1990s, with rising bond yields being bad for share prices. The problem for me is that I think inflation will rise in 2018 to just levels that this will be the catalyst for change in the markers. If you read the tea leaves, there is ample evidence of a change underway. Many commodity prices are doing very well. Copper prices are, as an example, reportedly at recent high’s due to increased production. If you look at producer prices in the US, they are inching up now over 3%. Even though wage pressures remain subdued, the pressure is building. Though participating rates for males in the US aged 25-54 are at near all-time lows, yes the employment rates seems low and may go lower, but there remains some slack to take up the growth we will see. But that pressure is there. I think that by the second half of the year, certainly by Q3, US inflation forecasts will show that 3.5-4% are on the horizon. This won’t cause a panic, but it will lead the change and correction that will come. On top of this the author suggests that the Fed may just “give in” to the needs to cap the bloated asset prices we see all around us, to nip the bubble before it becomes unsustainable. Trump’s tax deal will push this peak out a year or two, but the dynamics are in play.

Reading between the lines you can see that all three of the authors ideas overlap and intersect. Inflation is mentioned directly in 2 of the 3; growth is everywhere; public policy too. As such he has hedged his bets and tried to call out the category of challenge. I will try to break the triggers into more simplistic sections.

As such, I give the following percentage probability for each driving a correction by the end of 2018:

1. Monetary Tightening, most likely US led, due to over heating: 15%
2. China growth, debt to currency issues: 28%
3. EU or euro-zone debt or banking crisis: 15%
4. Inflation-driven policy changes: 22%
5. Japan public debt or growth challenges: 10%
6. Emerging Market currency or debt issues: 5% (this one won’t trigger in isolation but might follow from one of the others, namely 1, causing a currency drain)
7. Significant War triggering financial panic: 5%

Financial Times’ Martin Wolf Finally Get’s it Right

In “Fix the Roof while the sun is shining“, on Wednesday December 6th, Martin Wolf reports on how excessive low interest rates and quantitive easing create conditions that lead to rampant and growing debt, and now this might hold our newly growing global economy back. No kidding. It is about time that Mr. Wolf caught up with the rest of us. QE and near-do rates have were useful in saving the economy, but after a very short period of time we should have pushed rates up and had the Fed (and other central banks) withdraw from QE. If we had any form of real global central bank collaboration, this could have been coordinated together and thus no single region would have been subject to any disruption. We don’t have any form of Bretton Woods 2.0 and so we were all left to figure this out alone.

Now the newly recoding and growing global economy is now dunk on debt. We have sovereign states, states, cities and the public sector that have stoked up on cheap money. Worse this cash has not been used to drive growth economy that would have spun off profits to feed the governments, such that recovery would have improved sooner. If your home is anything like mine, the State of Georgia has rebuilt roads that were perfectly good before; and not added valuable new roads or services. The private sector has been buying back shares to drive EPS to feed the bonus needs of executives; and been gorging on M&A activity that was not driven by weak firms failing but hostile acquisitions of reasonably performing assets. On top of this, in some regions of the world (see Italy as a good example), zombie banks and firms have been hogging underperforming assets in the interests of keeping employment going. Thus the Nannie state is alive and well, dressed up in a veneer of free market economics.

Much has been written since the financial crisis about how moribund the state of economics are. It seems we no longer have a core base of trusted economists guiding anyone, let alone our political leaders. The economists are almost as decided as the politicians are. Yet even in the most basic of areas, debt and credit, we have failed. How on earth unrelenting debt, massive imbalances, and market-inflicting Federal involvement in the bond market would be a good idea but for a fleeting while is beyond me. The blind were leading the blind. At least Mr. Wolf has removed his blind. Let’s hope the rest do – and soon.

One small picture says it all

Standing about 2-3 inches tell and 1-2 inches across, a small chart in page A6 of this last weekend’s Wall Street Journal, sums up our economic predicament. The article, Japan Firms End Yearslong Price Freezes, reports that a growing number of businesses are reporting that labor shortages and increasing demand are leading to price increases. The chart shows a pleasing, gradual but clear rise in prices in Japan over the last year, now approaching 1%. This is important.

Though 1% inflation sounds measly for Japan it could be a short-term boon. The nation has been bedeviled for over 20 years with meager growth, stagnant wages, and tepid productivity growth. In fact some economist suggest that Japan’s fall from economic grace that preceded the West’s financial crisis of 2007, demonstrated early what would happen in a deflationary economy with massive quantitative easing. QE did not drive Japan’s economy to growth; it does not seem to have done so in the west, though it may have saved it from crashing and now we see how it’s persistence has led to financial and investment dislocation.

The news all around us is quite positive:

• Most recent quarterly GDP in US was restated up to 3.3%, almost unimaginable a year ago.
• EU economic growth rates are forecasted to grow above their recent meager levels in recent OECD reports
• ‘Currency war’ reports appear in the press infrequently, even though global trade remains torn by the idea that the US wants a stronger negotiating position (for what is, essentially, a very small part of the US economy).

But inflation remains stubbornly low almost everywhere. If Japan soon demonstrates ongoing growth in inflation, and global commodity prices push up, the result will be a wave of input price increase around the world. Some months later the US and more clearly the EU will see producer price increase and so consumers may see pass-through increases. This will encourage central banks to continue their march toward normality.

The downside with a return to inflation: Debt servicing becomes more onerous as interest rates increase in response to inflation increases. As such, governments and businesses that stocked up on cheap debt during QE and the near-zero interest rate period will have to squirrel away more cash to pay their interest charges. This will reduce what’s available for investment, thus slowing down growth.

The cycle feeds on itself so it can sometimes stabilize or other events can kick it into maddening swings. We will just have to see what happens. It may depend on how fast inflation growth returns. But for now, that little picture on page A6 looks very nice in a chilly autumn morning.