From “too big to fail†to “ too leveraged to tightenâ€
Landing in Lima, at sea level, our spirits are high. Tomorrow morning, we fly to Cusco, the Inca capital, 13,000 feet above, on our way to Machu Picchu where we would sight perhaps the most magnificent scenery we ever saw. Arriving at Machu Picchu via the Inca Trail, the first view of the citadel is from the Sun Gate, 1000 feet up. The scene is truly magnificent. From this perch, an uninformed eye would think the 500-year old citadel intact and vibrant. Perspective can be tricky.
Throughout our journey in beautiful Peru, most of it seeming almost halfway to the space station, the perspective was always grandiose.
Uber officers must also feel pretty high up there, declaring in the IPO prospectus that Uber’s Total Addressable Market (TAM) amounts to $12.3 trillion, equivalent to 14.5% of world GDP per Grant’s calculations. Left to itself, Uber could end up cashing $1 out of every $7 spent worldwide. Ambition on wheels.
Investors in technology stocks are ambitious people with high spirits. Never mind mundane details having to do with profitability and return on capital, they revere concepts such as TAMs and Lifelong Subscriber Value, focused as they are on the larger perspective offered by instantaneous global reach.
Much like the Incas who worshiped just about anything impacting their lives, tech investors see any company addressing people’s “needs†as godsends worthy of blind veneration.
Take the week after April Fools day. Jumia Technologies (JMIA), the expected Amazon of Africa, PagerDuty (PD), the latest arrival in the SaaS (software as a service) space and Tufin Software (TUFN) together raised $522 million on a $3.8 billion initial market cap, quickly revalued to around $6B as investors’ appetite far exceeded the 13% of equity offered. The old trick of starving the supply to create oversubscribed conditions…
If you care, these 3 companies had aggregate revenues of $310 million and operating losses totalling around $225 million in 2018.
The same week also saw one SPAC IPO, B. Riley Principal Merger (BRPM.U), raise $125 million. Don’t know what a SPAC is? There were 46 of them in 2018 that raised $10.7 billion from investors blindly volunteering money to a few people who will, it is hoped, be able to find an attractive company to acquire at good enough terms to justify the promoters eventually pocketing 20% of the pot.
As of 4/25/19, the Renaissance IPO Index, a market cap weighted basket of newly public companies, was up 33.4% year-to-date, double the S&P 500 gain.
Today’s investing crowd is truly faithful. Only solid faith can support a $90 billion valuation for a company having lost $12.1 billion in the last 5 years alone and whose business model is essentially based on a phone app and predatory pricing. Any comparison with Amazon is blind heresy.
While investors trip over themselves to buy IPOs of money losing companies with but vague prospects to ever become cash-flow positive, they digress infinitely about whether or not they should care if S&P 500 companies’ earnings decline 2% or 3% in the first quarter.
The Incas were focused on risk management, living where long rainy seasons succeed long dry seasons, surrounded by volcanoes and amid an earthquake prone geography. They proved very smart devising numerous ways and means to survive and prosper. And just in case, their numerous gods presumably had their backs.
But they had no gods prepared to help them face a danger in the form of Spaniards seeking to impose their own god while grabbing gold and various other natural resources in the process. Or was it the other way around?
Current day investors may also think that their central banker gods have their back but who knows what would happen if Spaniards, or Italians, or Brits or even Chinese for that matter decide to play hard ball.
The Oval Office may be near sea level but this President is way up in the clouds, oblivious to what is happening down below. Investors also seem to have high spirits in spite of admittedly poor data overall. In truth, nobody seems to care about the devil in the details.
For the Incas, the devil arrived by boat in 1532. The Inca Empire then covered a large portion of western South America including all or parts of today’s Colombia, Ecuador, Peru, Bolivia, Chile and Argentina. At its peak, the Inca population was estimated at between 6 and 14 million people.
They were nonetheless easily defeated by Francisco Pizarro’s army of 168 men, one cannon and 27 horses. Empires can be toppled by unsuspected forces, however unassuming they may appear. Pizzaro was both smart and lucky, using a divided population, smart communications, technology and trickery to surprise the Incas.
Pizarro was keenly attracted by the Incas’ gold and silver which, for them, had no monetary value but which they revered as the sweat of the sun (gold) and the tears of the moon (silver). Pizarro was perhaps the first corporate raider in history.
Incredible as it was, Pizarro’s victory caused Peru to become a radically different country. In just a few decades, most Peruvians became catholic, spoke Spanish and adopted the Spanish culture. Talk about an unbelievably improbable consequential event.
Donald Trump’s election may also prove to be fairly consequential.
Investors currently fear no devils. Jerome Powell quickly hid his horns at the end of December 2018 after financial markets sided with Trump on monetary policy. Two months later, Powell told Congress that he believes high corporate indebtedness could make any U.S. downturn worse.
Coincidentally, Dallas Fed president Robert Kaplan released an essay on March 5 (Corporate Debt as a Potential Amplifier in a Slowdown) with this conclusion:
I am also sensitive to these corporate debt developments in light of the historically high level of U.S. government debt and the forward estimates for the path of government debt to GDP. An elevated level of corporate debt, along with the high level of U.S. government debt, is likely to mean that the U.S. economy is much more interest rate sensitive than it has been historically.
To be clear, Kaplan told Reuters
It’s something that I’m aware of, which sort of reinforces for me why I feel we should be taking no action for some period of time (…) yet another reason why I think we are wise — inflation is not running away from us — I think we are wise to take a very patient approach.
From “too big to fail†to “ too leveraged to tightenâ€.
The Fed is wisely using a wide perspective to protect the U.S. empire. In effect, the government’s current and prospective debt combined with the huge corporate indebtedness are now variables significantly influencing monetary policy.
Add the President’s trade wars, Pelosi’s $1-2 trillion new infrastructure spending proposal and democrats’ Modern Monetary Theory printing machine idea and you have a Fed boxed in risk management mode praying that inflation remains low enough so that it can “wisely be patient†and allow the economy to grow enough to offset politicians’ and corporate officers’ fiscally irresponsible behavior.
But the Fed ain’t so wise. On the burning issue of excessive indebtedness, it actually is the chief arsonist with its “lower for longer†interest rate management experiment. Bernanke/Yellen’s message was a clear ticket for leverage. This Fed goes even further with it’s newly admitted “too leveraged to tighten†stance and its growing tolerance for rising wages and inflation.
Powell at his December 2018 presser post FOMC:
I do expect, and I think many forecasters expect, that wage increases will continue, and that would be a welcome development. Wage increases do not need to be inflationary. There’s plenty of evidence of situations, for example, in the very tight labor market of the late 1990s [when] (…) we had wage increases above productivity plus inflation. We didn’t have high inflation. So, it would be welcome. We hear a great deal of anecdotal information about labor shortages, along with other, you know, bottlenecks and things. So I would expect that wages will keep moving up, and it doesn’t necessarily mean inflation. We don’t think of it that way.
Investors, perched ever closer to heaven, trust that the new gods, Trump and Powell, will blend perfectly: one stimulating forever, the other providing the necessary low cost financing. Doesn’t that sound like MMT already?
However, investors’ focus on the gods of economic and monetary perfection prevents them from seeing the details in the devils.
When one drills down into this leveraged economy the narrower perspective becomes even more worrisome. As Grant’s reveals, only 15% of the $1.1 trillion leveraged loan market resides in public companies’ balance sheets. The other 85% is hidden within private companies’ liabilities. Iceberg, here we come!
In the last 5 years, the SEC-filers (public companies) have improved their debt/ebitda and interest coverage ratios while private borrowers, giddily showered with greedy cash, have shown a meaningful deterioration in both ratios to the point where the sum of all leveraged loan borrowers now shows debt vulnerability well in excess of the 2007 levels.
As a result, private companies, invisible to the investing public, are seriously sensitive to any rise in interest rates and/or any meaningful slowdown in the economy. Too leveraged to tighten. This, following a full year of tax reform benefits.
Private indebted companies and their private equity sponsors got the message last year that lower for longer may not be forever. The Fed’s sudden pivot opened a window which the Lyft and Uber of this world understood needed to be used hastily. Perhaps WeWork and others will also notice that investors are currently little bothered buying companies with losses larger than their revenues. One really needs to have long term vision to invest in such companies, vision only possible from way up there, where the gods hide the details behind their back.
The Investment Grade bond market also has a peculiar reality when one can focus on the details. This apparent safe harbor is now actually 50% populated by triple-B bonds, from 32% ten years ago. To this $2.5 trillion near-junk basket, we must add another $400 billion in BBB reverse‑Yankee bonds (U.S. companies issuing in euros) residing in the Euro IG basket. Ultra low interest rates prevent 55% of these bonds from being considered junk and sent to the High Yield junkyard based on leverage alone as per Morgan Stanley’s analysis.
History shows that 7-15% of BBB bonds get downgraded to junk in a recession. But today, never mind the recession risk, pre-emptive tightening can in itself cause significant downgrades and create a tsunami in the HY bucket which is only 40% of the size of the BBB market.
Given the large number of such companies on the IG-HY fence, even pre-emptive moves by the Fed can actually trigger the recession they want to prevent.
The ‘BBB’ mega borrowers are double that of the next-largest rating concentration – the ‘BB’ category – and a significant chunk of the investment-grade portfolio that together accounts for 59 percent of total ratings. (Fitch)
Zooming even closer, we see not only mega borrowers but also smaller companies having jumped on the lower for longer bandwagon.
According to Sun Trust, about 60% of small cap debt is junk-rated versus less than 10% for the S&P 500; 40% of small cap debt is floating. Moreover, 36% of the Russell 2000 did not produce earnings over the past 12 months, a record in non-recessionary years, 10 years into the economic cycle.
Interest coverage of the median Russell 2000 company is below 3.0, a level only seen during recessions. With 40% of the small caps’ debt floating, a 100bps increase in short-term rates would reduce their interest coverage by nearly 10%, potentially triggering defaults, restructuring, cost cutting (layoffs) and a tightening of lending standards.
Too leveraged to tighten.
It is now obvious that our central bank gods had but a wide, grandiose perspective on the USA land when they doubled short term interest rates during 2018. Investors went along, supported by the big corporate tax cut, until they started to see the 2019 details shaping up in early October.
Lower for longer has radically changed the complexion of America’s corporate world, so much that conventional pre-emptive policies could actually prove totally counterproductive. The Fed seems to have realized this new reality and swiftly pivoted early this year to the relief of equity markets.
But the Fed finds itself in a very uncomfortable box it has unknowingly designed. Its QE experiment now calls for experimenting how to exit a maze puzzle box having a thick but nonetheless very fragile and sensitive bottom.
Powell and company must be praying the inflation gods to stay put long enough to allow corporate deleveraging to happen. But President Trump has his sight on November 2020 now and any sign of slowing growth will trigger a stimulus attempt to keep corporate confidence high. Perversely, such confidence coupled with a quiet Fed are no incentives to deleverage.
The hope must be that receptive equity markets will allow for a quick rebalancing of debt/equity ratios, before inflation shows its ugly goddess head.
Too leveraged to tighten is also prevalent in Canada where it is the consumer that is too indebted for the BOC to become hawkish. And in Europe where the economy is still too weak for the ECB to let loose. And in Japan where the BOJ keeps begging the inflation gods to splurge on sushis. And in China where deleveraging is a goal only after the economy has clearly stabilized, courtesy of the USA, Europe and Japan if it ever happens. The true meaning of a sharing economy.
Concurrently, much of the world electorate seems to be shifting to the left as income inequality and populism grow in tandem and increasingly dominate political platforms.
In brief, the world seems totally synchronized with expansionary economic and monetary policies across the firmament. The only brake pressure comes from President Trump’s trade feuds, about to calm down, it is hoped by many. But given the damage to world growth, would a resumption in global trade flows spark faster growth… and higher inflation, tilting central bankers’ models towards their hawkish levers?
The timing could be perfect for the GOP and the elections of 2020. But the Fed and most other central banks might think it a little premature. Raising interest rates could well hit the corporate sector hard enough to hurt the economy and create chaos in both fixed income and equity markets.
Not raising rates would likely boost growth when additional labor resources are very limited. Since the 1950s, trends in inflation and labor costs have been pretty well synchronized and only recessions have succeeded in breaking the nasty upward trends.
Perhaps it would be wise for investors, not only to manage their current risk profile down, but maybe also to start thinking about the sweat of the sun and the tears of the moon. The Inca gold Pizarro and others were reportedly never able to take home has yet to be found.
As Paul Krugman once quipped, “Whom the Gods would destroy, they first put on the cover of Business Week.”
Aug. 13, 1979 April 17, 2019
Mark Twain said, “the reports of my death are greatly exaggeratedâ€. Inflation is not dead, and it’s a killer. Watch for its resurrection.