More haunting even than the terrified screams of lambs being led was the silence that followed their slaughter.
Such was the searing pain of relentless recollection for FBI agent Clarice Starling, the tortured lead played to Oscar perfection by Jodie Foster. In an agonizingly whispered scene that has forever left its imprint on the minds of horrified audiences, we hear the bleating of Starling’s long-dead tormentors.
Clarice’s hushed revelations to Hannibal reveal a desperate act by her young orphaned self. Unable to bear the horror, she’s running away from the bloodbath of spring lambs being slaughtered and her cousin’s sheep ranch. Desperate to do something, anything, she struggles to drive them from their pens to freedom: “I tried to free them…I opened the gate of their pen – but they wouldn’t run. They just stood there confused. They wouldn’t run…”
A recent, reluctant re-viewing of the film, only the third in history to win the “Big Five” Oscars, Best Picture, Actor, Actress, Director and Screenplay, fed fresh food for thought. The image of captives rejecting their freedom brought to mind another flock of corralled and stunned lambs — bond market investors. They too have been given the opportunity to escape their fate. But so many choose instead to stay. Such is the reality of a world devoid of options, with time ticking ruthlessly by.
Against the cynical backdrop of bulls and bears manipulating data to plead their case, Salient Partners’ Ben Hunt’s insights stand out for their indisputability. In his latest missive he points to one chart that’s incapable of being “fudged,” to borrow his term – that of U.S. household net worth over time vis-à-vis U.S. nominal gross domestic product. Suffice it to say we’re farther off trend than we were even during the dotcom and housing manias.
Hunt asks in what should be rhetoric but is lost on so many: “Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can’t diverge by a lot and for a long time. We can’t be a lot richer than our economy can grow.”
And yet we are. The culprit, which too few identify as such, is runaway asset price inflation led by debt markets that have grown to be unfathomably immense in size and scope. At $100 trillion, the size of the global bond market eclipses that of the $64 trillion stock market. A bigger discussion for another day comes from McKinsey data that tell us the worldwide credit market is over $200 trillion in size.
Zero in on Corporate America and you really start to get a picture of pernicious growth. According to New Albion Partners’ Brian Reynolds, U.S. commercial paper and corporate bonds have swelled by $3.1 trillion, or 63 percent, since the 2008 financial crisis. “This compares to nominal GDP growth of only 27 percent, so we are leveraging the heck out of the economy.”
For a bit more historic context, consider that U.S firms are more levered today than they were at the precipice of the financial crisis. According to Moody’s data, the median debt/earnings before interest, taxes, depreciation and amortization (EBITDA) is five times today vs. 4.2-times in 2008 for high yield companies. For comparison purposes, investment grade companies’ median debt/EBITDA is 2.6-times today compared to 2.2-times in 2008.
Michael Lewitt, the leading authority on all things credit and creator of The Credit Strategist, worries that companies are sitting on this pile of debt with not much more to show for it than, well, being in hock up to their eyeballs. “Much of this debt was incurred for unproductive purposes – buybacks, dividends to private equity owners, etc. – rather than for things that grow these businesses. Many high yield companies are not generating much, if any, free cash flow and are dependent on the ability to roll over their debt.”
On that count, there’s trouble brewing. Moody’s publishes a Refunding Index which gauges the bond market’s ability to absorb high yield bonds maturing over the next 12 and 36-month periods at the current pace of issuance. In the quarter ending in September, the one-year index was down 50 percent over the prior year while that of the three-year index was off by 40 percent continuing a protracted two-year slide. In dollar figures, three-year high yield maturities are up 45 percent year-over-year; they now total $156 billion vs. $108 billion a year ago. The flip side of these coins is that issuance is down by $13 billion.
“Debt maturities continue to increase at a rapid rate and are expected to rise to historic peaks within the next couple of years,” said Moody’s Senior Analyst Tiina Siilaberg. “And defaults are getting up there. Along with weak refinancing conditions, default rates for US speculative-grade issuers have been above five percent since May and ended at 5.4 percent in September. This compares to just 1.9% in May 2015.” Siilaberg expects defaults to peak at six percent in the coming months.
We can only hope Siilaberg is not being overly optimistic. A separate data set released by Standard & Poor’s (S&P) tallies the “weakest links,” or companies that are 10-times more likely than the broad high yield universe to default. In September, this count hit a seven-year high. For the moment, with an eye on recovering oil prices, investors seem to be operating under the assumption that stress in the pipeline is dissipating. Fair enough. But only one-quarter of the weakest links are energy firms. Chances are defaults, already at the highest level since 2009, will continue to climb.
As for the much bigger investment grade (IG) market, it’s not an energy story but rather one entangling the financial sector that promises to capture headlines in the coming months. S&P Managing Director Dianne Vazza recently warned that financials dominate the fallen angel universe, as in IG firms likely to be downgraded to high yield. The culprits include their exposure to energy firms, the fallout from municipal mayhem in Puerto Rico and weakness in global growth.
The immediate fallout for these fallen firms is a spike in borrowing costs. But even for those that manage to remain in the celestial, expenses could be poised to rise.
“The market is not waiting for Janet Yellen to raise rates on corporate debt,” warned Lewitt. “The risk is not default, but lower earnings as these investment grade companies borrowed enormous amounts to fund buybacks and dividends and have enjoyed an interest rate holiday that will sooner or later come to an end.”
That’s saying something considering that even with interest rates near their lowest on record, the interest expense among companies in the benchmark S&P 500 Industrials has been on the rise since bottoming at four percent of nonfinancial earnings in the third quarter of 2010. According to data compiled by S&P’s Howard Silverblatt, interest expense first topped six percent in the quarter ended March of this year. It remains above that level, the highest since recordkeeping began in 1993. Since then, we know borrowing costs have started to tick back up. With record debt loads, it’s safe to say many companies can simply not afford interest rates to rise off the floor.
As tenuous as the situation appears, this credit cycle may have one last rally in its gas tank. “I don’t think this is the big one,” said George Goncalves, Nomura’s Head of U.S. Rates Strategy. “However, I do view any sort of unwind of the ‘portfolio rebalancing effect’ hurting both stocks and corporate and sovereign bonds initially.” Once that panic sets in, though, expect sovereigns to regain the flight-to-quality status and stage a rally.
Goncalves does foresee one potential fly in the ointment of the relatively happy ending: “Ironically, a second Fed rate hike could trigger more currency devaluations from overseas, notably China. If the secondary markets cannot handle the volumes, it could lead to broad-based selling.”
New Albion Partners’ Reynolds doesn’t figure even an exogenous event could put the brakes on the current credit cycle. Pensions and insurers simply have too much in the way of fresh funds to deploy to allow that to happen; they’ve absorbed half of the $3.1 trillion in new issuance. Given more funds are expected to flow into pension coffers in the coming years as Baby Boomers retire in droves, there should only be more to come. So we go from the mammoth to the monumental when it’s game over.
“The cherry on top of the sundae of this credit boom is the shift away from money market funds to cash funds that take ten times the risk to get ten times the yield,” cautioned Reynolds. If you’re still game for a bit more irony, “This shift has nothing to do with the fundamentals. It is occurring solely because of the money market rule changes.”
It would appear to be only a matter of timing, and in turn, magnitude. The outcome though is undeniable. With defaults on the rise, refinancing capability in increasing danger and more distress building in the pipeline, you would think we would be hearing investors screaming. But we don’t. Just the deafening sound of silence as most in the herd refuse to be early, even if waiting with the gate to the pen open offers them ultimate salvation.