Let the music play

Let the music play.  Markets shrugged off the trade fears of prior sessions yesterday with all the major indices ending in positive territory.  In contrast Asian markets did not fair so well with Chinese equities closing in bear market territory.  Yesterday’s domestic move was helped along by small business optimism as reported here early in the morning.  Of course, Apple’s pre-release surge helped a bit as well.  Oh and did I mention, the sad but very real fact that home improvement and construction materials stocks traded up in anticipation of Hurricane Florence’s impending landfall and damage.  It’s not personal, Sonny – it’s strictly business.  So equity markets, rightly so, are focusing on the numbers and not the rhetoric.  Before I move on I have to add the caveat that if the rhetoric becomes reality and corporate profits and GDP begin to see negative effects, it will be a different story (and most likely not one with a happy ending).  This morning we received the latest read on the Producer Price Index and it grew at +2.8%, which is lower than the 3.2% expected indicating that inflation is still subdued for producers. This afternoon, we will get the Fed Beige Book, which will give us a broader view into the health of the US economy.  Ten year bond yields traded up yesterday and will start the session at 2.96% as they inch closer to that important 3% level.  As reported here on Monday, the US Treasury will issue an almost record (since 2010) of 3, 10, and 30 year maturities this week.  This month represents what some are calling the 10 year anniversary of the financial crisis, and with today being geek-out Wednesday, I thought it might be a good time to discuss credit bubbles.

On a Wednesday past I introduced you to Hyman Minsky and his financial instability hypothesis. You may recall that he discussed the various stages in which wild speculation leads to market bubbles only to be burst at great cost to investors once a panic sets in.  You may also recall that the now famous economist was largely unknown until his theories were applied to the 2008 financial crisis (AFTER THE FACT) and the term “Minsky moment” became a thing.  Let’s delve further into what comprises a bubble and what its implications may be on you.  Almost every self-respecting business school graduate and financial service professional has referred to, if not at least heard of Tulipmania.  It is perhaps the first recorded bubble and it took place in Holland during the early 1600’s.  The demand for rare tulip bulbs reached a fever pitch as investors began to seek overnight fortunes bidding up prices in a wildly speculative fashion causing the price of a single tulip bulb to reach a high of 10 times the annual income of a skilled laborer.  Ultimately a panic set in causing many fortunes to be lost and requiring government intervention in order to avoid major damage to the national economy.  So bubbles occur when there exists mass speculation and unwarranted value growth of an asset class as a result of anomalistic financial conditions.  In 2006, you may recall, home prices were skyrocketing allowing homeowners to refinance mortgages and cash out on the growth at a record pace.  Hundreds of billions of dollars were taken out of existing homes and re-invested in, amongst other things, more real estate and the stock market.  Additionally, opportunistic lenders were eager to lend money to home buyers to take advantage of the growing value of the collateral (real estate).  To oversimplify things a bit for this discussion, it was a debt fueled bubble.  By the time many realized that the underlying collateral was perhaps not worth as much as originally thought it was too late.  Panic set in as upside down mortgages prevented the sale of overvalued properties and defaults increased to a level which pushed lenders to the brink of collapse.  In fact many of those lenders did become insolvent.  Well you already know the ending of the this story: the economy sank into a global recession and the negative financial effects of the crisis ran across most, if not all sectors.  To combat the worst recession since the great depression, the Government and Federal Reserve embarked on an unprecedented stimulus binge.  For this conversation, I will stick to the Federal Reserve and its use of monetary policy.  The Fed is the ultimate keeper of interest rate policy and they held rates near zero from December 2008 through November 2015.  The intended effect of low interest rates is to enable corporations to borrow low cost capital in order to invest in growth through expansion, employment, and capital goods purchases thus putting the economy back into growth mode.  And that is precisely what corporations did… well mostly.  Low cost of capital has caused corporations to expand their borrowing significantly bringing the total value of outstanding non-financial corporate bonds to $11 trillion, nearly tripling since 2007.  Low interest rates also enabled many speculative grade companies to issue debt due to the lower cost of debt service. Growing, more speculative companies who could not perhaps even afford to issue debt in a high rate environment, were suddenly able to do so.  In fact, 22% of outstanding corporate debt is considered “junk” with another 40% being rated BBB, which is the level just above junk — that is 62% if you don’t want to do the math. OK, so all of this borrowed money was used to buy new equipment, expand plants, hire new employees, develop new technologies, etc. right? Wrong! Companies have also gone on a record stock buyback binge utilizing proceeds from bond issuance to buyback stocks, in effect shifting equity into debt.  Stock buybacks, as you know, are a great way to boost stock prices.  Last year, Congress enacted new tax legislation, which was a windfall for corporations.  Tax cuts along with reclassifications have added significant cash to corporate balance sheets.  Where do you think they spend that money?  If you guessed stock buybacks and dividends you would be correct.  Ok, so what is wrong with that?  The congressional budget office estimates that the new tax bill will add about $1 trillion to the national debt over the next decade.  In other words more borrowing!  So it should be clear by now that debt issuance on a corporate and even governmental level has reached some unheard of levels as a result of record low interest rates and fiscal policy.  The majority of the corporate debt is low quality, which means if things get rough for business as a result of a recession, companies may have a hard time paying back the debt.  With $1.5 trillion worth of corporate bonds maturing each year for the next five years, we can expect some defaults to ensue.  Unfortunately all of these facts are the makings of a debt bubble.  In this case, and in contrast to the 2008 crisis, it is corporate credit and not consumer credit.  To be clear, the financial crisis of 2008 featured many other factors that don’t exist today which means that the bubble burst will not have the same devastating impact.  However, it is prudent to be aware of the fact that there is, in fact, an institutional credit bubble that is building and it is contributing to the health of the stock market.  The best way to insulate investments for this or any financial turbulence is: diversification.  The best time to consider diversification is when things are going well and not to wait until the music stops playing and it is too late.

daily chartbook 2018-09-12


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