While Joe and I find it hard to imagine that a bear market started at the end of January or is imminent, there are a few vocal bears with more imagination than we have. We named three of them last Wednesday.
Today, we’ll focus on a 6/8 article in The Washington Post ominously titled, “Beware the ‘mother of all credit bubbles.’” It was written by Steven Pearlstein, a Post business and economics writer. He is also the Robinson Professor of Public Affairs at George Mason University. The article has been “trending,” with 555 comments (as of Monday evening) 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. I don’t disagree with Pearlstein’s conclusion: “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 is what typically happens: Rising interest rates eventually trigger a financial crisis when some borrowers fail to service their debts at the higher rates. The jump in bad loans forces lenders to cut lending, even to borrowers with good credit scores. The crisis turns into a contagion. A widespread credit crunch and recession result (Fig. 1). The stock market falls into a bear market (Fig. 2).
(2) Corporations will lead the next meltdown. Pearlstein correctly observes 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, 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 corporate (NFC) debt (which includes debt securities and loans) is back near record highs, having risen from $6.0 trillion at the end of 2010 to $9.1 trillion during Q1-2018 (Fig. 3). But NFC 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 on a downtrend 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 NFC corporate bonds outstanding was at a record high of $5.4 trillion during Q1-2018, doubling 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 claims 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. However, corporations collectively have always paid out roughly 50% of their profits in dividends, which 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 claims with no proof: “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 NFC 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 tax shelter for the bulk of the revenues earned by corporations.
(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, 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 NFC 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 been 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 claims: “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, 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 distressed asset and debt funds with billions of dollars waiting to scoop up distressed assets and debt at depressed prices may mitigate credit crunches. They may be the credit market’s new shock absorber. I believe that’s why the calamity in the oil patch was patched up so quickly without turning into a contagion and a crunch.
(7) But that’s not all, folks. At the tail end of his article, Pearlstein covers 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 does 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 cogently presenting 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, he does so as an alarmist, ignoring lots of evidence that doesn’t support his alarming points.
As I observe 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.”
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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