“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:
(Source: Bloomberg)
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.
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