Globally, the corporate default rate is about to spike. That will have serious consequences for the international financial system – though not all bad.
Rates are on the way up
Interest rates in the USA and the UK are going to rise – and more quickly than we thought. We know this because the central bankers keep telling us this is the case. Besides, we know that with synchronised global growth and aggregate demand running into capacity restraints in America and elsewhere there is simply no a priori economic justification for the near-zero interest rates that have prevailed for the last decade.
On Wednesday (21 March) Jerome (“Jay”) Powell, the new Chairman of the Federal Reserve, gave his first press conference in Washington. He made clear that the Fed henceforth would pursue a more aggressive monetary policy. Then, later that afternoon, he put his money (so to speak) where his mouth is, and actually raised the Fed funds rate – the rate at which the Fed lends overnight funds to banks in America – by one quarter of one percent from 1.5 to 1.75 percent.
This was the sixth rate hike since the Federal Open Market Committee (FOMC – the equivalent to the Bank of England’s Monetary Policy Committee (MPC)) began to raise rates from near-nothing in December 2015. The Fed Funds rate is closely tied to consumer interest rates, which generally rise as soon as the Fed moves. So American consumers will most likely notice an increase in their credit card interest charges very soon.
Along with the increase came another upgrade in the Fed’s economic forecast, and a hint that the course of rate hikes could be more dramatic than expected. Analysts now expect four rate hikes in 2018 plus a further three hikes in 2019. If each hike is of the normal 25 basis points then that would take the Fed Funds rate to a historically more “normal” 3.25 percent by the end of next year. Clearly, we are now at the end of the era of near-free money.
Fed economists raised their forecast for US 2018 GDP growth from 2.5 percent in December to 2.7 percent on Wednesday, and increased the expected outturn for 2019 from 2.1 percent to 2.4 percent. However, growth is likely to cool down thereafter with the 2020 forecast at 2.0 percent. The Committee noted that household spending and business fixed investment have moderated from their strong fourth quarter readings.
Clearly, we are now at the end of the era of near-free money.
As for the reactions of the financial markets, the yield on 10-year Treasury bonds barely moved, remaining at 2.9 percent, while the stock market hit a renewed bout of volatility but closed virtually unchanged. I explained in these pages three weeks ago the mechanisms by which rising rates drive increased stock market volatility – although, paradoxically, the VIX Index of volatility (derived from 30-day equity options prices) closed down at 17.86 having spiked the day before the rate hike was announced. The news should have buoyed the dollar but instead the greenback modestly lost ground against the euro and the pound.
On Thursday (22 March) the Bank of England kept rates on hold. But two out of nine members of the MPC voted for a rate rise. The remaining seven indicated that they will consider a rate rise in May[i].
The impact of Trumponomics
It now looks increasingly likely that the Trump administration’s combination of spending hikes and tax cuts will cause the US economy to overheat. Almost $400 billion of additional spending plus $1.5 trillion of tax cuts in an economy that is already operating near full capacity will be inflationary. Everyone knows that this will have to be addressed by successive interest rate rises by the Federal Reserve.
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In early March the IMF called on indebted governments to seize the opportunity offered by synchronised global growth to cut their borrowing. The fear is that many countries will enter the next downturn with government debt at near record highs. JP Morgan warned that the US fiscal deficit in 2019 will be the largest peacetime and non-recession deficit in history as a percentage of GDP. So, US government debt is likely to go up even as the economy grows. All things being equal, rising government debt puts additional upward pressure on rates.
While estimates of future growth potential remain flat (not least in the UK) the cost of servicing debt is beginning to rise, making it harder to refinance loans and bond issues as they mature.
The effect of rising rates on debt markets
Highly indebted companies are already going under. Last month Standard & Poor’s warned that high corporate leverage will trigger the next default cycle[ii].
As the default rate rises so banks stand to incur more loan losses, meaning that their loan portfolios become more risky. Most corporate loans globally – especially those extended to finance working capital and for the purpose of refinancing existing debt – are extended on a floating rate basis. That means the borrower pays the lender the cost of funds plus a margin commensurate with the risk represented by that loan (itself a function of the borrower’s credit standing and the maturity of the loan). The cost of funds is determined in the money or interbank markets and is normally LIBOR (London Interbank Offered Rate) for loans booked in the London market. The margin is the price of risk and is set by the bank in accordance with its internal risk models.
Now, as interest rates rise, and the global default rate increases as more borrowers go bankrupt, so the cost of risk rises and therefore lending margins rise also. That means that when borrowers seek to refinance existing debt they are hit by a double whammy: both the cost of funds goes up plus the margin.
LIBOR has risen significantly right across the yield curve of late – even in Sterling where there has been only one very modest rise in the central bank Base Rate (from 0.25 to 0.5 percent) on 02 November last year – the first rate hike by the Bank of England for a decade. As I write, 12-month sterling LIBOR stands at 0.97 percent – up from 0.224 percent one year ago.
Why do money market rates rise so much more quickly than base rates? The Bank of England Base Rate (and the Federal Reserve’s Fed Funds Rate) is an overnight rate – quite literally banks borrow the money for 12 hours from the central bank while they are shut in order to balance their books; while, in contrast, LIBOR is quoted over all maturities. During the period of near-zero interest rates the yield curve flattened to a pancake; now that rates are rising, and are expected to rise sharply, the yield curve is steepening rapidly. In a nutshell, the expectation of incremental increases in base rates causes money market rates to soar for longer maturities.
As for margins, in bank risk management terms, the Probability of Default (PD) of an outstanding loan asset surges as these money market rates rise. Thus margins – the cost of risk, remember – should increase dramatically. In a highly competitive banking system the market price of risk is dampened by competition as borrowers shop around for more competitive deals from lenders. But there is evidence that, since the Financial Crisis ten years ago when numerous banks were bailed out by governments, and given increased regulation and a lower appetite for risk across the board, the banking system as a whole has become less competitive.
A corporate borrower of good credit standing (say it has an A credit rating) which is borrowing one-year money today at US dollar 12-month LIBOR of 2.68 percent plus a loan margin of maybe 0.25 percent is paying interest on the loan at a rate of 2.93 percent. It is quite possible to envisage that when that corporation comes to refinance that loan one year hence it will have to pay LIBOR of 4.0 percent plus a new margin of 0.45 percent – so 4.45 percent. That means that its interest costs will rise by about 35 percent. That will hugely impact earnings for more highly indebted borrowers.
All zombie companies which do not generate sufficient return on equity to function in a “normal” interest rate environment are about to tumble like skittles.
Moreover, most loans extended to corporates, even highly-rated ones, carry covenants (conditions, if you like) relating to interest cover – the ratio between earnings and interest paid. If the interest cover ratio goes below a certain threshold then the bank has the right to call in the loan. This causes desperate borrowers to go cap-in-hand to lenders which charge higher rates. Remember, bankruptcies don’t happen because companies fall on their swords like Roman warriors; they happen because banks and other creditors knowingly and intentionally turn off the ailing companies’ life support machines…
When borrowers go bankrupt banks take a hit in so far as they have to write down the loan – though not normally to zero value. Their capital accounts reduce accordingly. There is normally some collateral (pledged assets) that the banks can seize and then liquidate – often in the form of money on deposit. So banks talk about something called Loss Given Default (LGD) – the percentage of the loan they will recoup even if the borrower goes bankrupt. As default rates rise so banks tend to demand more collateral in order to reduce their prospective LGDs. They also tend to raise fees and charges, increasing transaction costs across the economy.
What about the emerging markets?
Astute readers will point out that a large part of the world never experienced the decade of near-zero interest rates – including China, India and other leading emerging markets. Therefore, they should be immune from the forthcoming rise in rates in the Anglo-Saxon world and in Europe.
Not necessarily so. The Financial Times recently reported[iii] that emerging markets – at state, corporate and household levels – have racked up $40 trillion of relatively cheap debt since the financial crisis, about 30 percent of which is denominated in foreign currency (principally US dollars). As a result, numerous analysts have questioned whether the emerging markets’ debt pile is sustainable.
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In China, debt rose from 171 percent of GDP at the end of 2008 to 295 percent at the end of last September. Similarly, the combined debts of a group of 26 large emerging markets monitored by the International Institute of Finance (IIF) rose from 148 percent of GDP in 2018 to 211 percent last September.
There is some countervailing good news, of course. Aggregate growth is running at around five percent for emerging markets, their current account deficits are well down and their stock markets are attractively priced. Bond issuance by governments in emerging markets continues apace with investors apparently undeterred by Mozambique’s recent default. But some analysts like Fidelity International’s Paul Greer think that buyers of local currency emerging market government bonds are going to lose out. Overall, debtors in emerging markets are highly exposed to a sudden jump in the value of the US dollar.
Over in Brazil, the scandal-hit construction and energy conglomerate Odebrecht (private) is struggling to service its bond issues. Some see this as a taste of things to come.
Putting all this together, I can see four unfolding trends.
First, I predict that the ripple of defaults now beginning in the English-speaking world (Toys R Us is a case study in why debt kills – as I shall share soon) will become a tsunami of bankruptcies throughout the world as zombie corporations become unable to adapt to “normal” interest rates.
This tsunami will spread from the USA to the UK and then to Europe. And from there it will extend even to Asian countries which have not experienced near-zero interest rates, and to Africa. All zombie companies which do not generate sufficient return on equity to function in a “normal” interest rate environment are about to tumble like skittles. This will include companies large and small, including many well-known brands.
The banking system will quake; but I am confident that banks in Europe and America have built up sufficient capital cushions to withstand the level of losses – though their share prices will suffer. Possibly, a few financial institutions will totter; but I do not foresee a systemic banking crisis. I shall reveal soon the identity of certain banks in the emerging markets which look extremely vulnerable.
Secondly, for equity investors, it will be prudent to favour companies that are largely financed by equity above those reliant on debt. This means that young companies which are growing fast – which are normally thought to be high risk because of the volatility of their earnings (if they have earnings at all) – may turn out to be less risky than supposed. This is because they will not experience a rapid deterioration in their interest coverage ratios. In contrast, large, mature companies with high market share but low growth are normally financed mostly by debt. Such mature companies will now look more vulnerable as their net incomes and dividend pay-outs fall. Even where they survive, their share prices will suffer badly.
Thirdly, the bond markets will experience another flight to quality as markets react to new conditions. The bonds of highly indebted companies will be dumped, while those of lowly indebted companies will be snapped up. Refinancing costs in the bond markets will spike. This will be good news for governments: many institutional investors will reverse the recent trend and re-allocate from corporate bonds back to government bonds, thus driving government bond yields down – in the developed world at least.
Fourthly, in terms of the currency markets, with rate rises first initiated in America, the US dollar should strengthen. This trend will most likely be accentuated by the repatriation of US corporate cash piles from overseas back to the USA as a result of Mr Trump’s tax policies. That, of course, will be inflationary, thus putting more upward pressure on US rates. I foresee that there will come a point – reasonably soon – when the euro looks grossly overvalued as compared to the dollar; and there will be quite a sudden reversal of fortune between those two currencies. Thus far, the rise in the dollar has been attenuated by uncertainty about the Trump administration’s trade policies (about which more soon). That could change quickly.
A tsunami of corporate defaults will obviously be a drag on stock market valuations. On the other hand, companies with good business models and low debt will attract more investment. Overall, I am still optimistic that the major stock markets will continue to rise this year against a generally benign macroeconomic background. In terms of investment strategies, this year (and next) will be a great year for bottom-up stock-pickers who start with balance sheet analysis.
The twilight of the zombies will be judged a blessing as capital and labour are re-allocated to businesses with higher rates of return on capital.
In the medium-term, the twilight of the zombies will be judged a blessing as capital and labour are re-allocated to businesses with higher rates of return on capital. As I have argued before, zero interest rates have been a dampener on rates of return by artificially distorting the cost of capital. They have incited poor resource allocation decisions as the discounted value of future cash flows has been over-valued. (Correspondingly, the value of certain liabilities – most notably pension fund deficits – have also been exaggerated.)
We can expect much more outrage and hysteria on the left by this forthcoming Zombie Apocalypse – like that provoked by the collapse of Carillion in January this year. Carillion was a poorly managed company which had mispriced its service contracts for years. Moreover, its true level of debt was disguised by questionable accounting policies. Carillion was a zombie, and we are all much better off without it – but that is not how Mr Corbyn and his supporters would see it. There is, then, an element of increased political risk ahead.
The magnificent creative destruction of capitalism will shortly go into overdrive (and not even thanks to Mr Trump). But by the time the dust settles in about 4-5 years, a zombie-less world economy will have recovered its growth mojo – with the weird world of near-zero interest rates well behind us.
[iii] Financial Times, Big Read by Jonathan Wheatley, Wednesday, 07 March 2018, page 9.