One Bank's Surprising Discovery: The Debt Party Is Finally Over

Tyler Durden's picture

A recurring theme on this website has been to periodically highlight the tremendous build up in US corporate debt, most recently in April when we showed that "Corporate Debt To EBITDA Hits All Time High." The relentless debt build up is something which even the IMF recently noted, when in April it released a special report on financial stability, according to which 20% of US corporations were at risk of default should rates rise. It is also the topic of the latest piece by SocGen's strategist Andrew Lapthorne who uses even more colorful adjectives to describe what has happened since the financial crisis, noting that "the debt build-up during this cycle has been incredible, particularly when compared to the stagnant progression of EBITDA."

Lapthorne calculates that S&P1500 ex financial net debt has risen by almost $2 trillion in five years, a 150% increase, but this mild in comparison to the tripling of the debt pile in the Russell 2000 in six years. He also notes, as shown he previously, that as a result of this debt surge, interest payments cost the smallest 50% of stocks in the US fully 30% of their EBIT compared with just 10% of profits for the largest 10% and states that "clearly the sensitivity to higher interest rates is then going to be with this smallest 50%, while the dominance and financial strength of the largest 10% disguises this problem in the aggregate index measures."

Another key point that Lapthorne makes, as also highlighted here back in November 2015, is that the reason for this increase in debt is largely down to financial engineering – aka share buybacks (see charts below). However the most recent data points to a significant change in this trend with not only debt issuance in decline, but also the quantity of share buybacks.

Clearly over the long-term, this is obviously good news; borrowing money to buy back your elevated shares is clearly nonsense. However that has been the case for a number of years now. Are US corporates really waking up to the foolishness of their actions or are they constrained by their balance sheets? Or they may simply be anticipating greater clarity on Trump’s policies? Who knows! But in the short term, this does significantly reduce the impact of the biggest net purchaser of US equities, according to the SocGen strategist.

In other words, Lapthorne has found something surprising: after years of constant growth "having boomed out of control", net debt growth is rapidly heading toward zero, and perhaps even a contraction, for the first time since the financial crisis!

Needless to say, for an economy in which debt growth - either public or private - has been a primary driver of overall economic expansion, this is a stunning development. So what is driving it.

Here, Lapthorne makes several nuanced observations which have significant implications not only on future debt levels but overall equity prices and broader risk-assets:

Firstly, while the headline S&P 500 continues to move ever higher, the dynamics within the US equity market are not so encouraging. The chart below breaks down the FT US non-financial universe into top and bottom quintiles based on balance sheet strength (as measured by Merton’s Distance to Default). What is abundantly clear is that while the strongest continue to do very well, ever since the Fed surprised the markets back in February with a US rate move, stocks with the weakest balance sheets have struggled.

This goes to an observation we made last month, namely that virtually half of the S&P return has been due to a handful of high growth tech, (i.e., no debt) companies. At the same time, the average stock as measured by the equal-weighted performance, has also gone nowhere.

And here is where SocGen may have found something few have considered so far: "many are associating the surge in FAANG performance as a ‘go-for-growth’ play, but in a reality it looks like investors are running scared into cash rich companies."

Lapthorne's conclusion: "This is not a Trump policy play, this is balance sheet risk."

Lapthorne next highlights an odd discrepancy between equity and debt: the aversion to debt "may seem a little odd given that high yield bond yields are down at historical lows and the appetite for new issuance remains strong. What drives credit is typically a mixture of leverage levels, interest rates, asset prices and asset volatility. Corporate leverage ratios are currently high, despite near record asset prices, and while interest rates are gradually rising, credit spreads on high yield bonds have plummeted. Why? Well asset volatility is very low compared to historical levels, or to put it another way, asset price confidence is high. This, coupled with the continuous clamor for yield, is helping to compress corporate bond spreads. This overconfidence may be misplaced. If equity volatility were to move higher, lower quality bonds could struggle, as firms with poor balance sheets are already in the US equity market."

The chart below plots the relationship between long/short portfolios formed on balance sheet strength (again using Merton) and high yield bond yields. That they have a strong historical relationship is not surprising as both are measures of credit risk, but as such it is interesting when they diverge. For example there are only two instances in which we saw major divergences in the chart below. The first was the original Fed tapering bond sell-off in 2013. The second is today, with equity markets clearly balance sheet risk averse and credit markets seemingly incredibly complacent.

Going back to the core point made by the SocGen strategist, namely that investors are increasingly reluctant to lend to companies that already have a sizable debt load, Lapthorne points out, as one would expect, that where he has seen the greatest aversion to debt is within the smaller cap Russell 2000 index. A long/short balance sheet strength strategy is up 20% this year – the long leg is up 7% and the short leg is off 13%. To confirm this is not all about beta or cyclicality – a long portfolio formed on just price volatility is flat this year while the short leg is off 7%.

To summarise SocGen's unexpected finding which started by looking at debt incurrence among various "quality" strata of companies and ended up with implications for risk appetite for stocks: the strength of tech stocks (lowest amount of debt) and the Russell 2000 weakness (most debt) this year has nothing to do with Trump and everything to do with interest rate rises and balance sheet concerns.

And one final point from SocGen: "the problem with highly leveraged companies experiencing falling market caps is that it makes things worse, i.e. implied leverage and price volatility both go up!"

We wonder if Janet Yellen and her central bank peers are aware of these findings which have dramatic consequences for the Fed's treasured "wealth effect", as they set off to not only raise rates but also unwind record balance sheets, in the process exacerbating the divergence between a handful of no/low debt companies and the rest of the public market facing increasingly higher interest rates...

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Handful of Dust's picture

RadioShack suddenly closed more than 1,000 stores — and now only a handful remain

 

http://www.msn.com/en-us/money/companies/radioshack-suddenly-closed-more...

 

8 years of "robust recovery" has consequences.

Jim in MN's picture

OT, but, speaking of surprises:

http://www.reuters.com/article/us-mideast-crisis-syria-badia-idUSKBN18R1OI

Western-backed Syrian rebels said on Wednesday that Russian jets attacked them as they tried to advance against Iran-backed militias in a region of Syria's southeastern desert.

IndyPat's picture

Russia bombed ISIS.

This can't stand!

rf80412's picture

Most consumer electronics are sold and maintained at stores branded by the manufacturer or the service provider.  Smartphones have displaced a whole lot of specialized items for most people.  For the rest, you have big box stores like Fry's that sell everything Radio Shack does and lots more.

small axe's picture

Only bankers have the wisdom to handle debt wisely and use it for the common good. Says so on Page 666 of the Bible of Bankers, Book of Screw 'Em, New Keynesian Edition

Philo Beddoe's picture

Debt party over my ass.  

Consuelo's picture

 

 

+1000

 

It hasn't even begun...

JRobby's picture

Pointing to good old fashioned financial statment analysis and industry mean / variance here? (Laugh Track Deafening !!!)

IndyPat's picture

Print oil.

What an amazing idea.

Handful of Dust's picture

Debt party will probably not be over in my lifetime.

Pure Evil's picture

Nothin to worry about.

We'll just mint a few 1 Quadrillion coins and pay off that debt in no time at all.

Easy peasy lemon squeazy!

803Mastiff's picture

Something for nothing society. Cheese is always free in the mouse trap

Consuelo's picture

 

 

Yes, yes yes, we know...

 

Now then, I want a whiff of the stench from FB pink slips wafting through isles of the NAS before I believe anything is real.

 

 

directaction's picture

A cup of coffee will cost a million dollars before the debt party ends. You'll see.

rf80412's picture

And when it ends, a cup of coffee will cost a nickel in gold but most people will be left drinking boiled chicory they dug up on the side of the privately owned toll road, which used to be paved but is now dirt because it was the only way to turn a profit on each and every mile.

Bam_Man's picture

The "Debt Party" will end when the Central Banks stop printing.

That will not be anytime soon.

SeattleBruce's picture

Unlimited CTL+P has its consequences.

buzzsaw99's picture

looking at it all wrong imo.  this is actually bullish for the big corporations (the only things that really matter) because they can buy some of the little companies for pennies while benefitting from the death of others (the smaller competition). Monopoly money, monopoly corps.

 

oh, and for the CEOs of all those debt laden Russell 2000 companies, BONUS TIME!!

Batman11's picture

The US private debt data:

https://cdn.opendemocracy.net/neweconomics/wp-content/uploads/sites/5/2017/04/Screen-Shot-2017-04-21-at-13.52.41.png

Economy saturates 1929 and 2008 - CRASH.

Pathetic deleveraging since 2008 leaves little room for more debt before CRASH.

Private debt slightly higher than leading into the debt deflation of the Great Depression.

Batman11's picture

Japanese economy saturates with debt 1989 - CRASH.

It is has never recovered after making all the repayments on the debt taken out in the boom.

Batman11's picture

Today’s economics doesn’t look at private debt in the economy.

This is why the dickweeds at the FED didn’t see 2008 coming.

The dickweeds at the FED didn’t see 1929 coming.

They were using neoclassical economics then too.

Steve Keen was looking at private debt and saw 2008 coming in 2005.

Debt implosions in the near future:

China, Hong Kong, Norway, Sweden, Belgium, Australia, Canada and South Korea.

 

Batman11's picture

Someone with a brain wondered what went wrong in 1929 and the Great Depression.

Irving Fisher produced the theory of debt deflation in the 1930s.

Hyman Minsky carried on with his work and came up with the “Financial instability Hypothesis” in 1974.

Steve Keen carried on with their work and spotted 2008 coming in 2005.

The brain dead at the FED learnt nothing.

moneybots's picture

"The brain dead at the FED learnt nothing."

 

Back in the 1960's Greenspan wrote that 1920's FED policy lead into the Great Depression. Greenspan knew the lesson, then doubled down on 1920's policy, anyway.

Likewise, every member of congress knew why Glass Steagall existed. It was dismantled, anyway.

Likewise, the SEC knew leverage above 12 to 1 was dangerous. The SEC gave leverage waivers to the Big Five investment banks, anyway.

Likewise, congress change the bankruptcy rules in 2005. They knew in advance, what was coming.

Likewise, in 2014, the G20 changed the rules for depositors. They know in advance, what is coming.

Batman11's picture

They must also know there is going to be no take off for the debt saturated US economy, its turned Japanese.

 

ElTerco's picture

The Fed knows exactly how it all works. It's all a big scam to allow the most irresponsible people to own/keep the lion's share of assets.

daveO's picture

It's a quiet, hostile takeover of the economy. They know they can't do it violently, so they do it with fiat debt enslavement.

ElTerco's picture

To my knowledge, there has never been a deflation induced *government* collapse, even though there have been deflation induced *economic* hardships (please raise any counter examples if you know of them). On the other hand, there have been numerous recorded cases of inflation induced government collapse.

Rather than allowing deflation, which punishes irresponsible borrowers, the Fed will inflate it's way out of any deflationary problems, which rewards the debt holders and allows them to keep their assets at the expense of responsible savers.

That's the scam, more so than debt enslavement. It allows the rich to become ever richer with other peoples money.