“The Federal Reserve will not monetize the debt.”
- Ben Bernanke, June 3, 2009, then Chairman of the Federal Reserve, in response to a direct question on the subject during a congressional hearing
Maybe he really believed that at the time. There were plenty of skeptics out there on this point. Many of us worried that once the Fed started using the power of its balance sheet to create demand for debt securities, especially US Government bonds and mortgage-backed securities, that they would, in effect, be stuck with them. We are seeing this concern play out in real time today.
The Fed is the only entity in the world which possesses the enormous privilege of being able to create, at will, and near-zero marginal cost, US dollars. For now, the US dollar still enjoys its status as the most important currency in the world, and will probably remain so for the foreseeable future. Being able to print up as many as a situation calls for (or their digital equivalent) is an enormous privilege.
For the entire history of the Federal Reserve from its creation in 1913 until the onset of the Great Financial Crisis of 2008-09 (GFC), most people believed that if the Fed ever started blatantly printing up dollars in order to directly finance a ballooning US government fiscal deficit, that people would begin to lose faith in the dollar and its reserve currency status would be jeopardized. In short, it would be highly inflationary, much as it was when Germany did it after World War I, and as dozens of other examples of central bank “accommodation” played out throughout history.
Interestingly, it hasn’t really happened (yet). Of course, there has been broad inflation in certain places (housing, financial assets, health care, higher education), but generally speaking, most of that money never really made it out through the banking system into the “real” economy. These inflationary fears were reflected in the price of gold, which continued its rise leading up to and through the financial crisis before peaking in 2011 at around $1,900 per ounce. But then it started a steady decline, and while it looks like it is starting to rise in price again, it still sits about 30% below its peak 7 ½ years ago.
Prior to her departure from the Fed over a year ago, Janet Yellen laid out a plan for shrinking the Fed’s balance sheet back towards pre-crisis levels. And to their credit, they implemented that plan exactly as advertised. That plan continues to this day, allowing up to a maximum of $30B per month in treasuries and $20B per month in mortgage-backed securities to “roll-off” the balance sheet and allow those dollars to disappear back into the financial ether from which they came.
As outlined in last month’s post, the new chair of the Fed has intimated that they are much more open to reversing this normalization than had been broadly believed as recently as a few months ago. If they do in fact stop this process of “rolling off”, then it will effectively freeze the Fed’s balance sheet near current levels ($3.98T as of Feb 20 2019).
Prior to the GFC, the Fed’s balance sheet had always been comfortably below $1 trillion.
So, if they do what it looks like they are going to do, which is to stop their balance-sheet reduction plan in its tracks, they will have effectively blown up their balance sheet by a factor of 4x and will be holding around $3T worth of debt securities that were funded directly through the Fed’s dollar-creation process. This is the legacy of quantitative easing (QE).
If that is not monetizing the debt, then I don’t know what is.
This is precisely why, in my mind, both the stock and bond markets were selling off so dramatically from early December until Christmas. Recall, this is when President Trump’s criticism of the Fed and Jay Powell were reaching a crescendo. You can get away with these shenanigans for a while, but once the perception takes hold that the Fed is captive to the politicians, the game is over because the quality of the currency and its appropriate role as a reserve currency for the world will be brought into question.
Only once it was made clear to the markets that Jay Powell’s job was safe did the markets start their dramatic recovery, which continues to this day.
The ultra-accommodative policies of the Fed (and the other central banks of the world) has had a dramatic effect on the values of financial assets. The most immediate effect of QE was to create additional demand for debt securities by introducing a very large and price-insensitive buyer of government bonds and mortgages. Even though the Fed has not directly purchased corporate debt securities (yet), this has happened elsewhere in the world. Even so, the immediate effect of the US QE program was to lower the interest costs for the issuers of those bonds (especially the US Government), and since the entire credit market takes its cues from interest rates on US government bonds, rates were brought down across the entire spectrum.
So even though the Fed was not directly providing financing to US corporations or other issuers of debt, they all directly benefitted from their activities because they were able to issue debt at much lower interest rates than would otherwise had been the case.
And issue they did:
And why not? Just as artificially low financing rates encourage consumers to borrow money to buy cars and appliances, artificially low rates in the corporate bond world encourage companies to borrow money for all sorts of reasons.
One of the most popular uses of all of this cheap money is to buy back the company’s own stock:
The actual total of announced buybacks for 2018 exceeded $1 trillion, and there has been no slowing of this trend in spite of increasing criticism being leveled by prominent people, including elected officials.
I am not taking issue with stock buybacks, per se. If a private company wants to take full advantage of artificially cheap credit and harvest that available cash from investors, and then turn around and give that money to their shareholders by reducing the outstanding share count, that is their business. It actually makes sense, as long as the stock is being purchased at an attractive price.
And there is the catch. Unfortunately, corporate America has a pretty bad track record in this regard, as can be seen in the above chart. Stock buybacks hit their peak in the previous cycle in 2007, right before the S&P 500 lost 57% of its value.
Now we find ourselves with a situation that can be fairly described as such – corporate America is in the later stages of completing a leveraged buyout on itself. In the grand scheme of things (recall that central bank accommodation has enabled the global debt bubble to grow from $170T to $250T over the past decade), this swelling in US corporate debt up to $9.3T or so is a relatively small piece of the puzzle but a very important one. Despite the fact that the US comprises only about a quarter of global GDP, it’s publicly-traded stocks comprise closer to half of the value of all stocks traded around the globe.
It is important to remember at this point that, as an equity investor, you are at the bottom of the food chain in the corporate structure. Yes, you, as a group, are the only ones who are entitled to share in the profits of the companies you invest in, but only after everyone else has been paid. This includes the employees, the parties who have contracts with the company, preferred stockholders, and all creditors.
As an investor in US stocks, understanding that you have the most junior claim on companies assets and cash flow if they fall on hard times, how do you feel about the fact that these companies have taken full advantage of these artificially low rates, borrowed trillions of dollars, and used most of it to leverage up their balance sheets instead of investing in things that will create future revenues?
Uneasy – that’s how I feel about it. And again, these junior claims on US companies comprise about half of the value of the global stock market.
The picture looks even worse when you start to look at the quality of all that corporate debt:
Its’ arguably never looked worse. BBB-rated bonds are the lowest level of so-called “investment grade bonds”. As you can see, that sleeve has grown to become a larger and larger share of the investment grade US corporate debt universe. At the onset of the GFC 11 years ago, it made up around 30% of the total. Now it is over half:
Its’ actually 54% now. The reason this is so important is not simply that it is a reflection of the deteriorating credit quality of the pile of US corporate debt. All of these issuers of BBB-rated debt are one downgrade away from a BB rating, and that is significant because BB is considered non-investment grade, or “junk”.
While there is a time and place for most investors to have some exposure to these “junk bonds”, a lot of institutions can’t and won’t hold them. So, if we were to see the economy slow down, or interest rates rise, or both, we should expect to potentially see a record amount of debt added to the pile of junk (which is already around $3T when including bank loans made to non-investment grade issuers).
When a company loses its investment-grade credit rating, its interest expenses go up, a lot. Given the amount of debt which is due to mature over the next few years, forcing these issuers to either retire the debt or refinance it, potentially at much higher rates than were on offer when the Fed’s QE program was in full swing, it would not be surprising to see these companies cash flow and earnings deteriorate over the next few years.
This is the point of this post. There has rarely, if ever, been a better time to focus on quality.
One of the biggest problems with index funds, particularly those designed to track capitalization-weighted indices (S&P 500, MSCI EAFE et al), is that they are indifferent when it comes to fundamental issues such as the balance sheet and leverage ratios. The only thing that matters with these cap-weighted indices (which comprise the vast majority of index funds and are capturing virtually all of the net new investment dollars these days), is the total market value of the company, or put another way, price. In theory, a highly-leveraged company which has been issuing debt with reckless abandon and not showing much in the way of net profits, should have its stock price marked down as a consequence, but it doesn’t always work out that way (Hello, Netflix).
Since these cap-weighted index funds have become so incredibly popular, we are seeing a record amount of money being allocated to stocks on the basis of price alone, without regard to other issues such as quality.
It doesn’t have to be this way. There is no rule that says that we have to invest in companies carrying record levels of debt who will almost certainly be facing much higher interest costs at some point in the future, and maybe the near future. One might expect to have to pay a premium on the basis of top-line sales or bottom-line earnings to own these higher quality companies with stronger balance sheets, and there are certainly examples of that out there, but in general, it doesn’t appear to be the case at this point in time.
As an investor trying to earn a decent return on your capital, and rightfully concerned about risk, why wouldn’t you do that? I look at the pile of US corporate debt today the same way I would look at an active volcano that may not be erupting right now, but could conceivably do so at any moment. I want to stay as far away from it as I reasonably can.
Any opinions are those of Accordant Advisory Group and David McKee and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information provided does not purport to be a comprehensive description of securities, markets, or other developments. This information had been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information provided is not a complete summary or statement of all available data necessary for making an investment decision, nor does it constitute a recommendation.Investing involves risk and investors may incur a profit or loss. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The MSCI EAFE (Europe, Australasia, and Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. The EAFE consists of the country indices of 22 developed nations. U.S. government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in counties that have the potential for instability; and the market is unregulated. Investing in oil involved special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors.