Thursday, July 5, 2018

Mother of All Credit Bubbles?

A 6/8 article in The Washington Post was ominously titled “Beware the ‘mother of all credit bubbles.’” Author Steven Pearlstein is a Post business and economics writer and the Robinson Professor of Public Affairs at George Mason University. The article has been “trending,” with 555 comments since it was posted on the Post’s website. I received several emails from accounts asking me to comment on it. So here goes:

(1) The end is coming. Pearlstein concluded his article as follows: “It’s hard to say what will cause this giant credit bubble to finally pop. A Turkish lira crisis. Oil prices topping $100 a barrel. A default on a large BBB bond. A rush to the exits by panicked ETF investors. Trying to figure out which is a fool’s errand. Pretending it won’t happen is folly.”

I agree that there will be another credit crisis—eventually. In my book Predicting the Markets, I show that most of the post-war recessions were triggered by rising interest rates. Here’s how that typically happened: Rising interest rates triggered a financial crisis when some borrowers couldn’t service their debts at the higher rates. The jump in bad loans forced lenders to cut lending across the board, even to borrowers with good credit scores. A widespread credit crunch resulted, taking on crisis proportions. The crisis grew into a contagion, and recession ensued (Fig. 1). The stock market naturally fell into a bear market (Fig. 2). It bottomed once the Fed started easing credit conditions to end the crisis.

(2) Corporations will lead the next meltdown. Pearlstein correctly observed that the previous credit bubble was inflated by “households using cheap debt to take cash out of their overvalued homes.” This time, in his opinion, the epicenter of the coming debacle is “giant corporations using cheap debt—and a one-time tax windfall—to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks.” This is where we part ways.

Pearlstein calls it the “Buyback Economy,” where future growth is sacrificed for current consumption. The article quickly turns into a liberal progressive rant claiming that corporations are “diverting capital from productive long-term investment.” Instead of investing for the long term, they are engaging in “financial engineering” by converting equity into record debt. And needless to say, this is all making the rich richer. And who are the rich? Round up the usual suspects: They are corporate executives, wealthy investors, and Wall Street financiers.

It’s true that nonfinancial corporations’ (NFCs) debt—both debt securities and loans—is at a record high, having risen from $6.0 trillion at the end of 2010 to $9.1 trillion during Q1-2018 (Fig. 3). But NFCs’ liquid assets ($2.7 trillion during Q1-2018) and cash flow ($1.8 trillion over the past four quarters) continue to set new highs. The ratio of NFC debt to liquid assets is matching its lowest readings since the mid-1960s (Fig. 4).

The ratio of NFC short-term debt to total debt has been falling since the 1980s (Fig. 5). It is down from 40%-45% during the 1980s and 1990s to roughly 28% during the current economic expansion. This confirms that NFCs have been extending the maturity of their debt to lock in lower interest rates.

(3) Corporate bond debt at record high. It is also true that NFCs’ corporate bonds outstanding was at a record high of $5.4 trillion during Q1-2018, having doubled since the mid-2000s (Fig. 6). But again, this may partly reflect opportunistic lengthening of NFC debt maturities. The spread between gross and net NFC bond issuance rose to a record high slightly exceeding $600 billion last year (Fig. 7 and Fig. 8).

(4) Buybacks are troubling. Pearlstein claimed that buybacks amount to “corporate malpractice,” observing that companies have been spending more than 100% of their net profits on dividends and share repurchases. That’s true. Historically, however, corporations collectively have paid out roughly 50% of their profits in dividends rather than investing for the long term; that use of profits has never been viewed as malpractice (Fig. 9).

The sum of buybacks plus dividends has been running around 100% of S&P 500 after-tax earnings (Fig. 10). That means that buybacks have been 100% funded by retained earnings (i.e., after-tax profits less dividends). Even so, Pearlstein claimed without supporting evidence: “The most significant and troubling aspect of this buyback boom, however, is that despite record corporate profits and cash flow, at least a third of the shares are being repurchased with borrowed money, bringing the corporate debt to an all-time high, not only in an absolute sense but also in relation to profits, assets and the overall size of the economy.”

Not so fast: Retained earnings are just one portion of NFCs’ cash flow, which is also determined by the capital consumption allowance (CCA), i.e., depreciation reported to the IRS (Fig. 11). I like to think of the CCA as a huge tax shelter for corporate earnings.

(5) Corporations have been eating their seed corn. Progressives like Pearlstein are most incensed about how corporations aren’t investing in the future. Instead of buying back their shares with 100% of retained earnings and even borrowing to do so, the thinking goes, they should be spending more on plant and equipment. They should be paying their workers more and providing them with the skills they need to make their companies more productive, so that real incomes can grow.

What are the facts? The data show that NFCs’ gross capital expenditures are at a record high (Fig. 12). These outlays continue to be funded predominantly by cash flow in general and the CCA in particular (Fig. 13). Net fixed investment broadly has matched the spending pattern of the past two expansions (Fig. 14).

The data also show that net bond issuance has been relatively small compared to cash flow (Fig. 15). Cash flow has been ample, financing lots of capital spending and share buybacks. So buybacks haven’t come at the expense of capital spending. Furthermore, as noted above, corporations have refinanced and extended the maturities of lots of their debt at lower and lower interest rates (Fig. 16).

(6) Corporate borrowing is increasingly risky. Pearlstein claimed: “In recent years, at least half of those new bonds have been either ‘junk’ bonds, the riskiest, or BBB, the lowest rating for ‘investment-grade’ bonds. And investor demand for riskier bonds has largely been driven by the growth of bond ETFs—or exchange traded funds—securities that trade like stocks but are really just pools of different corporate bonds.”

Furthermore, Pearlstein said he is troubled that “a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs, or collateralized loan obligations, which are sliced and diced and sold off to sophisticated investors just as home loans were during the mortgage bubble.”

This may be Pearlstein’s most credible concern. Lots of junk has been piling up in the corporate credit markets, just as it did in housing’s subprime credit calamity during the 2000s. However, there was a significant stress test from the second half of 2014 through the end of 2015 in the high-yield market. The collapse of the price of oil caused credit quality spreads to blow out, especially for the junk bonds issued by oil companies. With the benefit of hindsight, that was an amazing opportunity to buy junk bonds.

My working hypothesis is that future credit crunches may be mitigated by all the distressed asset and debt funds that are around these days, with billions of dollars just waiting to scoop up distressed assets and debt at depressed prices. They may be the credit market’s new shock absorber. I believe that’s why the recent calamity in the oil patch was patched up so quickly without turning into a contagion and a crunch.

(7) Dangerous excesses abound. At the tail end of his article, Pearlstein covered all the bases with the usual litany of other credit market excesses. Rising interest rates and defaults could send ETF prices into a “tailspin.” The “global economy is now awash in debt.” The US budget deficits will exceed $1.0 trillion per year on average over the next 10 years. Household balance sheets are in worse shape than widely recognized. Margin debt is at a record high. He did concede that “[While] banks are in better shape than in 2008 to withstand the increase in default rates and the decline in the market price of their financial assets, they are hardly immune.”

Pearlstein deserves credit for having cogently presented the dangers lurking in the credit markets, which have almost always been the epicenter of potential trouble for the economy and the stock market. However, writing as an alarmist, he ignored lots of evidence that doesn’t support his alarming points. I don’t disagree that there may be another crisis—eventually. As I observed in my book, “I’ll go out on a limb and predict that there will be another financial crisis in our lifetimes. However, like previous ones, it probably will offer a great opportunity for buying stocks.”

(8) Accentuating the negatives. Pearlstein is an experienced financial journalist writing for a reputable publication, so I am not disputing all his assertions. My beef is that he accentuates the negatives and ignores the positives for NFC debt discussed in the reports he cited from the US Treasury, International Monetary Fund (IMF), and Moody’s. Trouble may be brewing for NFC debt, but there really aren’t any indications of stress yet.

Pearlstein notes: “‘Flashing red’ is how this buildup of corporate debt was characterized by the U.S. Treasury’s Office of Financial Research [OFR] in its latest annual report on the stability of the financial system.” I agree that it is hard to ignore the red boxes in Figure 20 in the OFR’s report. The red represents high “potential vulnerability” for US NFC credit risk based on corporate leverage ratios, which compare debt to assets and earnings. On the other hand, the same figure in the OFR report also shows green boxes, which represent low potential vulnerability—i.e., ample ability for US NFCs to cover their interest obligations, based on the ratio of earnings to interest.

The OFR reported: “On the positive side, many companies have rolled over existing debt at lower interest rates, while also lengthening maturities of their debt. These steps make servicing the outstanding debt less costly and boost these companies’ creditworthiness. In 2017, almost 60 percent of high-yield bond deals, by count, included repayment of debt as a use of proceeds. This is the highest level since at least 1995.” The OFR added: “Excluding commodities-related companies, the default rate for non-investment-grade, nonfinancial corporations has held steady at about 2 percent in recent years.”

“The International Monetary Fund recently issued a similar warning” about the level of NFC debt, noted Pearlstein. But notwithstanding the high level of NFC debt, one of the IMF’s key findings was that the allocation of corporate credit isn’t nearly as risky as it was before the 2008 financial crisis. In the IMF’s April Global Financial Stability Report, Chapter 2 focused on the IMF’s new global measure of the riskiness of credit allocation as an indicator of financial vulnerability. The IMF found that “a period of high credit growth is more likely to be followed by a severe downturn or financial sector stress over the medium term if it is accompanied by an increase in the riskiness of credit allocation.”

The riskiness of credit allocation at the global level has rebounded since its post-global-financial-crisis trough back to its historical average at the end of 2016, observed the IMF. Yet it is not nearly as high as it was when it peaked at the onset of the global financial crisis (see Figure 2.4.1. on page 63 in Chapter 2 of the IMF’s report). “The relatively mild credit expansion in recent years, combined with postcrisis regulatory tightening, contributed to a softer rebound in the riskiness of credit allocation than might be expected given the very loose financial conditions,” explained the IMF.

“Mariarosa Verde, senior credit officer at Moody’s, the rating agency, warned in May that ‘the record number of highly-leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives,’” observed Pearlstein. Indeed, Moody’s May report contended that “the non-financial corporate debt burden today is higher than its peak before the 2008-09 financial crisis.” However, Moody’s also found that “the near-term credit outlook is benign and the speculative-grade default rate remains low.”

(9) Hedge clause. Needless to say, I've accentuated the positives to counter Pearlstein's comprehensive litany of negatives. The most obvious risk for stocks these days is trade protectionism rather than the bursting of a credit bubble. That's a subject for another day.

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