New Crisis Is Brewing 10 Years After Last One And Why That’s No Surprise

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageThe financial crisis of 2008-2009 was no ordinary crisis. It brought the U.S. banking system to its knees, destroyed millions of jobs, and nearly caused the break-up of the Eurozone. And this is just a short list of the damage it caused. Given how bad it was, it may have been reasonable to expect that we would now have a system in place to prevent another debacle. But ten years have passed and the idea that we have learned our lessons seems at best quaint and at worst laughable.

One of the most basic lessons not learned is that a massive buildup of debt tends to end in a serious financial crisis. Even a small liquidity event that gets in the way of rolling over higher and higher amounts of debt eventually brings down the whole edifice.

This is not a revelation. Even the Tulip Mania of the 1630s that ended up in a crash was fueled by a huge increase in leverage created by tulip “futures.” Most recent debacles such as the 1982 Latin American debt crisis, the 1990 Savings & Loan crisis, the 1990 Japan crash and the 1997 Asian crisis can all be traced to out-of-control credit growth. And, of course, the 2008 crisis had at its core an exponential chain of leverage built around mortgage derivatives.

In the aftermath of the 2008 crisis, a river of ink was spilled to condemn the runaway debt spiral that led to it. It is remarkably ironic, then, that as we crawl out of ten painful years of struggle and recovery, even the most outspoken fiscal hawks of that time now seem unconcerned that debt is growing apace once more.

This is, alas, not surprising. As Prof. Richard Kindleberger from MIT put it in his 1978 classic book “Manias, Panics and Crashes” some time has to pass after a crisis “before investors have sufficiently recovered from their losses and disillusionment to be willing to take a flyer again.” Ten years, it seems, qualifies as enough time for the party to resume.

Despite an economy that by all measures has recovered well, if not spectacularly, the U.S. has just decided to unleash a large and most likely unnecessary fiscal stimulus that will bloat public debt and fiscal deficits. But government is not alone in abandoning prudence. The private sector, spurred by rock-bottom interest rates, has gorged on debt. This is true not only in the U.S. but also across the globe.

Three areas, in particular, point to areas where credit expansion may be growing at unhealthy rates.

Fiscal deficits

The Congressional Budget Office projects the fiscal deficit to double to 5% of GDP from 2015 levels, and federal debt, as a result, to grow to nearly 100 percent of GDP by 2028 from the current 75%. And these are just projections; the actual deficit numbers for this year are looking even worse. Indeed, the 2018 FY projection (which ends in September) is for a deficit of $804BN, but we already racked up $898BN in the eleven months that ended in August.

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Private debt

Corporations everywhere took advantage of interest rates at all-time lows, borrowing as much as they could in the last few years. Many companies in the U.S. used the proceeds to buy back their own stocks.

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The amounts are staggering. According to a report by the McKinsey Global Institute, corporate bonds around the world issued by non-financial companies have almost tripled since 2007 from $4.7 TN to $11.7TN. Of particular concern is that the largest credit category of overall corporate debt (loans, bonds and credit lines) and the one that grew the fastest is BBB, sitting just above the edge of “junk.”

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Most of the outstanding corporate debt instruments (Includes bonds, loans, and revolving credit facilities rated by S&P Global Ratings from financial and non-financial issuers) are at the bottom of the investment grade tier.S&P Global Fixed Income Research, Path Financial LLC

Higher interest rates or a slower economy may affect the ability of any given company to service, roll over or repay that debt, which then leads to a downgrade into the “non-investment grade” (i.e. junk) category. This, in turn, forces some bondholders to liquidate their holdings. If this goes beyond an isolated event, the risk of downgrades snowballing into a liquidity crisis becomes real.

Margin debt

The 1929 stock market crash was driven, in part, by a speculative mania that relied heavily on borrowed funds to buy stocks. While today’s margin debt levels are a far cry from those heady days when it reached more than 8% of GDP, it is now at its highest level in decades.

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History shows that beyond a certain level, debt burdens become too heavy to bear. It is not clear what that level might be, when it will happen, or how severe a crisis could get.

There are some mitigating factors today, such as a less-interconnected global economy (yes, there is an upside to less globalization) that limits avenues of contagion, and a better-capitalized banking system that seems better prepared to deal with a systemic crisis.

In addition, the relatively fast economic growth that the U.S. is experiencing, although brought about by the same fiscal expansion that is bloating debt levels, offers a good opportunity to get serious and put in place policies that can help us deal better with future crises. This is to say that it is not yet too late to avert a repeat of the 2008 disaster – if only we embrace the lessons of the past.

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This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Investors Are Main Lenders To U.S. Businesses, But May Not Understand Risks

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageFaced with regulatory constraints and stricter guidelines, bank lending to businesses declined since the financial crisis. The business sector filled the void by issuing bonds, which were quickly swallowed by yield-seeking investors. This amounted to a transfer of lending risk out the banking sector and into the investor class. This is good news for the banks, which are now in better shape, especially in the U.S.. The bad news is that, unlike banks, the investor class has no safeguards if something should go wrong. Also unlike banks, the average bondholder is ill-prepared to ascertain credit risk. And there are signs that the risks bond investors face are increasing.

There is no doubt that the role of investors as lenders to businesses has become more prominent. In the U.S., for example, companies in the non-financial sectors now have well over twice as many bonds than loans outstanding. In Europe, although bonds are not a widespread source of private sector financing, the proportion of bonds still nearly doubled with respect to loans since the financial crisis.

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Another reason to worry is that U.S. corporate bonds rated at BBB by Standard and Poors represent the largest group by far, at 37% of all non-financial corporate bonds outstanding, or $2.7 trillion. This is a credit rating category at the very bottom of the “investment grade” ladder. Bonds downgraded from this BBB category fall to the “non-investment grade” land where many investors are forbidden from entering. Thus, a downgrade that pushes a bond across that divide triggers selling that can drive the bond price even lower.

There is a large wave of bonds maturing in the next five years, which could be as large as $10 trillion globally according to the McKinsey Global Institute report. These bonds will be replaced with new ones that would be more costly if they are issued at higher rates than the ones maturing. This is likely to be the case, since interest rates are going up. Bonds at the threshold of investment grade quality could easily fall into the “junk” world.

There is also the issue of bond liquidity. The McKinsey report reminds us that “buying and selling corporate bonds often requires a phone call to a trading desk at an investment bank, and there is little transparency on the price the buyer is quoted”, a feature that can seriously curtail bond liquidity if a credit event were to take place.

Mutual funds – the largest holders of corporate bonds – can easily withstand the first wave of redemptions with their cash holdings, but because many funds hold similar positions, a selling wave could pose a problem when everyone is on the same side of the trade. Both practitioners and academics like Caitlin Dannhauser of Villanova University and Saeid Hoseinzade of Suffolk University have studied this point in depth.

A liquidity crisis is more likely today, when trading desks at investments banks that used to hold large bond positions are now restricted from doing so. Bond holdings of primary dealers, for example, have steadily declined and are now about a fifth of what they were before the financial crisis, even as the outstanding amount of bonds more than doubled.

Investors are now much more exposed to business lending risk because of their large holdings of corporate bonds, a risk that will increase if economic conditions suffer. While the economy is currently firing on all cylinders, it is vulnerable to the tightening efforts of the Federal Reserve, a slowing global economy and the risk that today’s trade disputes could turn into a full-scale global trade war.

Any of these issues could push some corporate bonds over the non-investment-grade category, severely affecting bond prices. While it is unlikely that bond weakness could turn into a broad crisis, bondholders will be hurt. They need to pay close attention to the risks they face, especially because nobody will be there to help them if their investments sour.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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How the tax bill made the next recession much more painful

today blog photoIf the stock market rally was a party, someone would be wondering if the punch bowl should be taken away. The tax bill, instead, has refilled the bowl to the brim. Party fun goes on, and the coming hangover has just gotten worse.

Shortly after the bill passed, Walmart, AT&T, Comcast and many other companies announced $1,000 bonuses to hundreds of thousands of employees. And this is peanuts compared to the large and permanent reduction in the corporate tax rate corporations get. The breaks extend to a mountain of profits accumulated abroad and a variety of loopholes that may lower taxes even further when they bring them back.

Corporate America was already flush with cash. The extra pile courtesy of the tax bill will spur some marginal increase in business investment and wages (as the $1,000 bonuses show), but the historical relationship between taxes and economic activity suggests that this effect is bound to be small.

Far more importantly, the extra money will accelerate stock buybacks. Data by the US Federal Reserve shows that corporate repurchases of stock have been a major source of demand for equities and arguably the most important factor in pushing stocks higher in recent years. Because it operated under the radar of individual investors, general belief in the soundness of the bull market never caught on. But now the tax cut is in place, and people are increasingly aware that offshore money will mostly go to dividends and repurchases. This is bringing a lot of investors in, pushing stocks even higher.

The tax cut, therefore, not only will have some marginal effect on economic activity, but also a hugely positive impact on the demand and supply of stocks. This makes it without a doubt a positive for the stock market. So what is not to like?

In our view, the tax cut comes exactly at the wrong time.

Back in the aftermath of the financial crisis the world desperately needed a fiscal shot in the arm – lower taxes, higher spending, or both. But politicians in the US and Europe, claiming concern by high levels of debt, declared that austerity was the only acceptable way to fight the crisis and denied the world of this medicine.

This was an enormous policy error. Without any fiscal help, central bankers were forced to engineer a global recovery through aggressive monetary loosening, at the cost of severe distortions such as zero (or negative) interest rates, massive asset inflation, and a huge accumulation of private debt.

But monetary authorities accomplished their goal. The world is firmly in growth territory, the US is at full employment, and inflation has stayed low. Not only we came out in pretty good shape, but conditions are now ideal for dealing with those distortions created by “unconventional” policies.

The tax bill, however, injects a sharp fiscal stimulus that not only is unnecessary at this time but also creates the opposite problem. If the economy speeds up too much or inflation starts rising, central bankers could be forced to raise rates too quickly to keep things under control. This is dangerous in a world with high indebtedness. And once again, fiscal and monetary policies will be at odds.

Even if inflation stays low and the economy does not overheat, the tax cut is bound to increase levels of public debt by at least $1TN over the next decade, according to the Congressional Budget Office, the Joint Committee on Taxation, and the Tax Policy Center. This will leave even less room for deploying fiscal tools (i.e. higher spending and/or even lower taxes) to fight the next recession when it comes.

This is a serious issue. While things look good right now, the business cycle is not dead. The current expansion has been running for 104 months straight, and we are well positioned to break the 120-month all-time record. When the streak ends, the size of outstanding public and private debt are very likely to be much larger than in 2008.

And it is a good bet that, unless the world’s political landscape changes radically, politicians will again be horrified by levels of debt and refuse to stimulate the economy through fiscal means, just as they refused during the last crisis. Monetary authorities will have no choice but loosening policy way too much, and the cycle will start all over again from a more extreme point of indebtedness.

Thus the tax bill has quite certainly, and unnecessarily, made future downturns far more painful than they needed to be. But when people party they don’t think about hangovers, especially when everybody was served another round. Higher stock prices in the short term are likely. What may happen later will not be as fun.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Huge change in market conditions and what it means for fund fees

newsletter imageFees charged by fund managers have come under attack, and this is especially true for “active” funds that try to beat an index. In recent years, they have struggled to perform better than much-cheaper “passive” funds that simply match their benchmarks, so their higher fees have been harder to justify.

From this, some observers have concluded that active management has proven to be pointless and all investment in the future will be passive – that is, nobody will even try to beat a benchmark anymore. This is a wild exaggeration, to say the least. Active management will have its moment in the sun again, and, as we will see, that moment may be coming soon.

Critics also accuse active managers of barely deviating from their benchmarks anymore. If that is true, they provide little, if any, added value or diversification, and therefore they are charging too much for a job they are not even performing.

There is some validity to the claim that active managers have not been very “active” in recent years. But there is more to this than meets the eye.

We measured the correlation between some popular large-cap mutual funds and the S&P 500, and found credible evidence that after the financial crisis “active” funds indeed became more “passive”, i.e. more correlated with the index. The group we studied, which includes funds large and small, clearly provided much less diversification or additional value over the S&P 500 from 2008 to today.

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But it may be incorrect to conclude that managers have simply become too lazy to do their job. A deeper look at market dynamics suggests that scaling back their efforts to outperform the market was a rational response to a significant change in market conditions.

When we looked at the characteristics of this group over 20 years, we found that regardless of size, the funds least correlated with their benchmarks performed better than the ones that followed their benchmarks more closely. In other words, the ones that were more “active” reaped the largest returns.

But the last 9 years of so show a very different picture: the closer those funds matched the index, the better they performed. Trying to produce returns different from the index was not a successful strategy. What changed?

graph two

The simplest explanation, and the one that much of the financial media has embraced, is that managers have indeed gone lazy or “lost their touch.” In our view, it is quite unlikely that a whole industry of professionals could have somehow become incompetent almost overnight.

The more likely explanation is that a change in market dynamics made it much more difficult for them to beat their benchmarks. If this is so, then we need answers to three questions: what kind of change took place; did managers respond to that change correctly; and is that change temporary or permanent. The answers to these questions yield a much more favorable picture of active managers than the financial media has been willing to paint.

After the financial crisis, individual stock price changes became highly synchronized, making it very hard to identify which stocks would deliver above-average returns without increasing portfolio risk beyond prudent levels. There is plenty of evidence that this is the case.

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Trying to squeeze extra returns from assets that move close together is a losing strategy. Margins are slim, and whatever a manager may be able to extract is likely to be wiped out by trading costs, behavioral biases, and mistakes. In such an environment, the rational response for a professional portfolio manager is to embrace the benchmark. Interpreting this as a sign of laziness or ineptitude is too harsh. In our view, active managers came to a realistic admission that they cannot beat the market through stock-picking when stock correlation goes through the roof.

The opposite is true when correlation drops. When the spread between outperforming and underperforming stocks widens, the reward for choosing the “right” basket of assets is much higher. Leaving aside the much-debated question of whether it is actually possible to identify such basket, the fact is that in low-correlation markets, such basket in principle exists and its potential payoff is much higher.

A high-correlation environment became prevalent after the financial crisis, but it is finally coming to an end. In the last few months, inter-asset correlations have dropped noticeably and, remarkably, the group of funds we studied has itself become less correlated with the index. Active management seems to have been doing its job all along – decoupling with the index when correlations were low and hugging the index when correlations were high.

The decline in inter-asset correlations has important consequences. First, it argues against the premise that in the future all investing is destined to become passive (i.e. merely index-following). As stock picking becomes once again a likely source of excess returns, the attraction of active funds will grow. Second, it bodes well for the market as a whole. Lower correlation is usually accompanied by a drop in volatility, which is a key component in bringing back the retail demand for equities, which has been weak in the wake of the financial crisis. All this supports our view that the mid- to long-term outlook for risky assets such as stocks has significantly improved, and that the bull market is far from over.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk.

You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Contact Path Financial here.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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IMF Financial Stability Report Says Debt Binge Leaves US Corporate Assets Exposed

IMF says debt binge leaves US corporate assets exposed (ft.com)

IMF says debt binge leaves US corporate assets exposed (ft.com)

A debt binge has left a quarter of US corporate assets vulnerable to a sudden increase in interest rates. This is an issue Path Financial has been watching and writing about since 2015 (read our most recent analyses on this topic here (“Beware the Mountain of Debt” and here (“This is Where the Next Debt Crisis Will Come From“).

In its twice-a-year Global Financial Stability Report released earlier this week (April 19, 2017), the International Monetary Fund warns that the ability of companies to cover interest payments, by one measure, is at its weakest since the 2008 financial crisis. Historically, the scenario of large debt accumulations, combined with rising interest rates, rarely ends up well. Investors should be paying close attention to these red flags.

At Path Financial, our portfolio management process is focused on measuring and managing risk — a strategic and effective approach in creating a sensible balance between risk and return. Contact us to learn how we can help safeguard your investments: 941.350.7904.

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Junk-Bond Wake-Up Call Column Quotes Raul Elizalde of Path Financial

herald tribune logoIn his newspaper column in today’s Sarasota Herald Tribune, contributing columnist Ernest “Doc” Werlin quoted Path Financial President and Chief Investment Officer Raul Elizalde on the topic of the current challenges facing the junk-bond market. Drawing from Path Financial’s Dec. 15 article for investors, “Junk Bond Troubles Could Be the Tip of the Iceberg,” Werlin noted Elizalde’s comment that “it’s too soon to say the worst is over for investors….It took over a year for the earliest signs of serious problems in the mortgage bond market to metastasize into the collapse of Lehman Brothers and a full-blown financial crisis.” Werlin also quoted Carl Icahn’s Dec. 12 appearance on CNBC where Icahn “warned that a lack of liquidity could cause the high-yield market — otherwise known as the junk-bond market — to implode and contribute to a broad market crisis.”

Read Werlin’s full column here.

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