Beware the Mountain of Debt

mountain of debtBoth interest rates and stocks soared after the US election. This is because everyone seems to agree that the new US administration will spend a lot, collect less in taxes, and cut back regulations.

This is a mix that could fuel the economy and be good for stocks. Not so with bonds: It will likely lead to higher interest rates as inflation rises, the Fed fights it with higher policy rates, and firmer economic activity pushes market rates higher.

It could also backfire on stocks if high inflation and higher wages actually drag economic activity down. Furthermore, higher US rates relative to rates abroad are sure to push up the US dollar, hurting exporters and manufacturers. This could also weaken the economy, bring down corporate revenue, and dim prospects for stocks.

This would be a worst case scenario of higher nominal rates and a decelerating economy. It is known as stagflation, and it has a reserved spot next to deflation as a nightmare scenario for policymakers.

Also, the economic policies that the new administration has so far hinted at are radically different from what has been the norm in the past few decades. This guarantees that they will face strong headwinds before they can be implemented, including congressional opposition. There is a chance that the consensus scenario may never materialize, may be watered down, or may take far longer than the market is willing to wait. So the optimism about stocks can prove to be short-lived.

Regardless of whether stocks go up or down, it is quite likely that Interest rates will remain above the historically low levels of last year, or climb even higher. This could exacerbate vulnerabilities in the economy that have so far gone relatively unnoticed.

One such issue, and a well-known trigger of past crises, is a large accumulation of private debt.

Debt is a key factor in lubricating economic activity: Households use it to buy homes or cars that could not otherwise afford, businesses use it to finance investments or fulfill orders in advance of payment, municipalities use it to pave roads and lay out utilities, and so on. Without debt, growth would be slow, halting, and ultimately impossible.

Households, businesses and governments always carry debt on their balance sheets, and constantly take new debt to replace the one that comes due. When rates go up, the cost of rolling over debt goes up as well. That is why higher rates tend to dampen economic activity, which is a normal swing in the business cycle.

But when indebtedness becomes too large, the balancing act of renewing old debt with new one becomes more difficult to pull off for reasons other than cost. Lenders start questioning the sustainability of the process, especially if rates go up sharply, and sources of funding dry up. Large debt accumulation then leads to a liquidity crisis, just when access to financing is needed the most.

The last few years of ultra-low interest rates sparked a massive increase in US business debt. The opportunity to borrow at some of the lowest rates in recorded history was too good to pass up.

But the new debt has not been used primarily to invest in the economy: much went to build cash reserves, and some more to buy back stocks or increase dividends. In the last couple of years private domestic investment has gone down while the stock of private debt continued to grow.

The earnings-to-net-debt ratio for S&P 500 corporations – a key measure of borrowers’ ability to reduce their debt levels – is at its lowest level in at least a decade, according to the research firm Factset. And while some analysts find comfort in the fact that corporate cash is also very high at $1.75tn, the reality is that much of it is concentrated in just a few technology companies: Google, Apple, Microsoft, Cisco and Yahoo account for a third of all US corporate cash.

We showed the chart below in various newsletters in the past and we updated it with the latest numbers. The chart shows that there has never been a larger or faster 4-year accumulation of non-financial business debt. Not surprisingly, prior surges of indebtedness ended in tears.

This is not solely a US problem. China, most pointedly, has seen an explosive ballooning of private, non-financial corporate debt that just reached an eye-popping 170% of GDP.
Some early signs of a brewing debt crisis would include an increase in corporate credit rating downgrades, Chapter 11 restructurings, liquidity problems in the bond market, and so on. So far, these symptoms are not evident, but conditions could turn optimal for a debt crisis if interest rates rise quickly, budget deficits get out of control, and economic activity does not pick up.

Even without a sudden crisis, it remains to be seen how the mountain of global corporate debt can be gracefully wound down without anyone getting hurt. History shows that large debt accumulations rarely end up well. Close attention to any early warnings will be crucial to navigate through the rest of 2017 and beyond.

What now?

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. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper 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. Read more.

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Merrill Lynch fined $430mm for “unprecedented violations”

According to OnWallStreet magazine, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) slapped Merrill Lynch with massive fines for misusing client’s cash while failing to safeguard their securities, and for failing to disclose material facts to clients about structured notes products.

The major claim by the SEC was that Merrill artificially reduced required cash deposits in customer accounts to free up billions of dollars per week to finance its own trading activities. The SEC said that if any trade had collapsed, Merrill’s customers would have been exposed to massive shortfalls.

In addition, Merrill disregarded rules for years by holding up to $58bn per day of customer securities in clearing bank accounts that were not shielded from claims by third parties and subject to general liens.

Merrill admitted to the wrongdoing. The article can be found here.

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Bulls and bears fight it out

After two years of virtually uninterrupted gains, the stock market took a scary tumble in  October. Opinions are highly divided on what this means.

The bulls think that the dip is a buying opportunity because the economy is strong and  the Fed’s ongoing stimulus places a bottom on asset prices. The bears say that the economy is vulnerable to serious global challenges against which the protection that Fed policy supposedly provides will come short. The fight between the sides is closely contested, and investors are caught in the middle. Erring on the side of prudence may be the way to go. Read the full report

Written by Raul Elizalde

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Some love for the most unloved bull market in history

A recent Standard & Poor’s report confirms that investors were net sellers of equity mutual funds from early 2009 through late 2012, even though the S&P 500 climbed more than 50%. But since the beginning of 2013 they have been net buyers, even though amounts have been modest and participation inconsistent.

Some observers argue that, as always, investors are coming in too late, lulled into a false sense of security by high prices and low volatility. In this mindset, this is a proverbial “calm before the storm” – nothing but a trap. Are they right?

We don’t think so. By one measure, the market may be at the beginning of a healthier phase. We know this is hard to believe. (Read more)

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Two conditions keeping investors on edge

In case you haven’t noticed, the S&P 500 has been breaking records since April 2013. Just this week it crossed the psychological 1900 level for a brief moment. But while this is happening, aggressive stocks like small caps are losing a lot of ground to far more conservative large caps. The same is happening to the consumer discretionary sector, which has performed dismally against consumer staples.

There is little evidence – actually, none – in the last 14 years that a market rally like the one we are experiencing can take place without aggressive stocks being at the forefront of performance. To pessimists, this is a clear warning that the market is heading for trouble. Are they right? (Read more)

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