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.

one

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.

two

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.”

three

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.

four

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.

——————-

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

——————-

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.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather

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.

——————-

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.

facebooktwittergoogle_pluspinterestlinkedintumblrmailby feather