Imperviously shielded by the S&P 500’s presumably impermeable umbrella, most investors appear blissfully oblivious of threatening storm clouds billowing up on the horizon. The collective consciousness has a vested interest in perpetually sunny skies. Consequently, its myopia is dangerously out of touch with the vicissitudes of weather, or for that matter, business cycles.

Consistent with human nature, a long stretch of good times correlates with the assumption that the immediate past will continue unabated into the future. Instead of becoming progressively more risk-averse, the majority of consumers and investors alike extrapolate the prosperous present seemingly in perpetuity, embracing more and more risk as memories of the penalty for doing so fade farther and farther into the misty recesses of time. Like every other aspect of human experience, cycles—some like clockwork, others seemingly random—keep the pendulum of life from swinging too far away from equilibrium. Economic expansions and contractions are not immune from this action/reaction duality that Ralph Waldo Emerson called the “law of compensation.” Within every cause, Emerson reasoned, grows the seed of its own effect. [1]

For us moneychangers, acknowledging a difference between the weather and business cycles is not without value. I believe the former is actually more predictable and thus it’s somewhat easier to harness weather’s power on the one hand and avoid calamitous mistakes on the other. Farmers in our region can usually assess with some accuracy when conditions are right to seed their fields and when conditions and their crops are ripe for harvest. Farming is not for the faint of heart, though. Floods, droughts, unforeseen foreign-trade disputes, unpredictable commodity prices—to mention just a few risk factors—still regularly put even the hardiest of farmers to the test.

Beyond the virtue of patience, investors have much to learn from the humble guy in coveralls behind the control console of his John Deere. After many daunting decades earning a diploma from the school of hard knocks, is it any wonder the presumably wealthiest farmers don’t reside in McMansion homesteads? At some point, the titans of Wall Street, according to Emerson’s reasoning, extrapolated, will find themselves up to their knees in slop. Bill Gates once said, “Success is a lousy teacher. It seduces smart people into thinking they can’t lose.”

Gresham’s Law: Alive and Relevant

As noted in our last post, the International Monetary Fund (IMF) published its latest Global Financial Stability Report last month. What attracted our attention was the dramatic change in narrative since its last report six months ago. It cited the effect of trade disputes on business sentiment, economic growth, and capital spending, resulting in a shift toward a more dovish monetary policy stance globally, accompanied by declining long-term yields which, they contend, may temporarily mitigate some of the recent concerns.

Kicking the cathartic can of economic cyclicality down the road—as not-on-my-watch policymakers have seemed want to do ever since the 2008–09 financial crisis—has enabled, if not actually fomented, the formation of the aforementioned storm clouds. Financial risk-taking has grown apace, resulting in a build-up of financial vulnerabilities. Alas, in the current environment reckless behavior is once again proving contagious in a perverse race to the bottom.

In terms of its contribution to overall economic well-being, debt incurred to fund mergers, acquisitions and share buybacks is next to worthless. Both activities attempt to circumvent the economically pivotal role of a vital corporate sector—growing its capacity for making something or serving somebody. Record levels of M&A (mergers and acquisitions) activity in the U.S., a euphemism for buying what someone else built, have been spurred in part by a relatively unknown windfall buried in the Tax Cuts and Jobs Act of 2017 which permitted the markup of intangibles associated with debt-funded acquisitions. Moreover, an epidemic in the flagrant abuse of EBITDA (earnings before interest, taxes, depreciation, and amortization) add-backs utilized to inflate earnings projections, has enabled borrowers to reach deeper into the pockets of lenders.

Over the first half of 2019, highly leveraged transactions accounted for 60% of leveraged-buyout (LBO) deals, surpassing pre-crisis highs. All things considered, what masquerades as enlightened corporate finance today is little more than the board game with the apropos title, Monopoly.

Even the buyback charade has more than a smidgen of sleight-of-hand, much like supposed equality with nothing on the other side of the = sign. What’s left unsaid is that a substantial portion of the shares purchased in the open market actually apply to offsetting the dilution that would otherwise result from grants of stock to executives and employees. According to John Hussman, over the last 15 years the net effect of buybacks and new-stock issuance on the per-share growth of S&P 500 earnings, revenues, and other fundamentals has amounted to just 0.78% annually. Parenthetically, that revenue has grown at only a nominal rate of 4.1% over the same time span, after including any benefit from corporate stock buybacks. Thus, the massive increases in the index values are not a result of substantially fewer shares, but rather near record-high valuations paid for those shares.

The October IMF report emphasizes the negative effect on nonfinancial firms from slowing global growth and on-again, off-again trade disputes. Not only have corporate sales begun to slow in China, Europe, and the United States, still robust U.S. profit margins have begun shrinking too. The post-financial crisis spike in profit margins was attributable to high unemployment and muted labor-cost inflation.

The worm has turned.

Rising real-unit labor costs are highly correlated with contracting profit margins. Low unemployment is actually a leading indicator as it begins to limit growth rates. The businesses that compose the S&P 500 have been unable to escape the economy-wide sales and margin contraction. To be sure, among the 13 major S&P sectors, some are far more sensitive to economic cyclicality than others. Still, the worse any upcoming recession might become, the farther its tentacles will reach. As noted at the outset, the behavior of the S&P index in the aggregate would suggest that neither long-term investors—more and more of whom are passive indexers—nor active investors are concerned enough about deteriorating fundamentals to vote with their dollars. To be sure, there has been sector rotation in the direction of buffering portfolios against a possible economic hiccup by relative-return investors. Net of all such machinations, however, the S&P continues to hit new highs.

Funny Money … Again?

Given the shortness of financial memory, we shouldn’t be surprised. The riskiness of credit allocation ratcheted up significantly in major advanced economies beginning in 2016, nearly a decade since the last trip to the woodshed. With the post-financial crisis repentance theme a thing of the past, the estimated-share of speculative-grade corporate debt has ballooned to nearly 50% in both China and the U.S. Applying the IMF’s metrics, the U.S. has the dubious distinction of boasting the highest ratio of the particularly troublesome debt-at-risk in the corporate sector—25%.[2]

In its own model of stress testing, the IMF posited a 2021 adverse economic scenario triggered by the risk factors outlined in the report: A GDP shock only half the severity in terms of GDP contraction during the global financial crisis was applied to all countries. Interest rates paid by firms would rise to 50% of the level during the crisis, credit spreads would widen significantly, profit margins would come under pressure, and limited liquidity would make quick deleveraging problematic. Under this scenario, debt-at-risk in the U.S., China, and the United Kingdom would exceed pre-financial crisis levels. Under the same scenario, speculative-grade debt would migrate toward debt-at-risk status. In the aggregate, the total debt-at-risk (debt owed by firms that are unable to cover their interest expenses with their earnings) for the world’s eight largest economies totals $19 trillion, 40% of total corporate debt outstanding.

It boggles the mind to realize it won’t be until the mushrooming debt-at-risk undergirding this latest Ponzi scheme comes a cropper that regulators and novices will surely shudder in disbelief at the extent of the willful negligence. As a note of caution to readers at least vaguely aware of the reckless train careening down the rails, it’s wise to keep one’s ear glued to the tracks and pay attention to what one hears. By the time billowing smoke can be seen and the steam whistle heard, the chance to get out of harm’s way will have passed.

Conclusion and Prescript

Easier financial conditions also have elongated the corporate credit cycle, with the concomitant expansion of financial risk-taking by corporations, figuratively fresh snow on an already critical-state, avalanche-prone mountainside. During the global financial crisis, countries with high leverage in the banking and household sectors experienced more severe recessions. We believe that in the next credit-contraction cycle, another narrative may prevail: corporate deleveraging. Involuntary shrinking of the liability side of corporate balance sheets will, for the many companies with dangerously thin equity cushions, necessitate the fire sale of assets at precisely the wrong time.

The backpedaling of risky corporate behavior will amplify shocks to the economy, as disinvestment invariably leads to declining employment among the labor force. Where once unthinkable default becomes the only option, financial intermediaries will be hit with losses and, perhaps more importantly, they will become gun-shy lenders, helping to intensify and deepen the credit malaise. Involuntary asset sales and born-again conservative lenders are symptomatic of the terminal phase of virtually every runaway expansionary credit cycle. And the one we’re in now is a doozy.

None of the risky assets highlighted in this essay would ever have come to market were it not for willing buyers. They and their motives will be analyzed in our next post.

[1] Martin, Frank K. A Decade of Delusions (pp. 431–432). Wiley. Quoting Emerson, Compensations. “Cause and effect, means and ends, seed and fruit, cannot be severed; for the effect already blooms in the cause, the end preexists in the means, the fruit in the seed.”

[2] Debt-at-risk is defined as debt at firms with an interest coverage ratio (ICR) below 1. The interest coverage ratio is defined as EBIT (earnings before interest and taxes) relative to interest expense. Speculative-grade debt is defined as debt owed by firms with an ICR of less than 4.1 and net debt/assets greater than 0.25, where net debt is gross debt minus cash.

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