For years, one of the biggest issues facing the economy has been excessive debt and leverage. Yet even with these problems, prior to COVID-19 it was commonplace to see headlines in the financial media that read…
“Current Bull Market Continues To Climb A ‘Wall of Worry’” (1)
The “wall of worry” is one of the phrases frequently used to illustrate the resistance or fear of investors to invest in a stock market that had earlier gone down. Since the Great Recession of 2008 and the financial crisis many investors have worried about the possibility of another financial crisis.
In a 2018 conversation with clients I was asked about a recent stock market pull back and if a problem in the market… could cause another financial crisis. This was an issue that was on many people’s minds these days.
A decade of Quantitative Easing, low rates, and slow growth have forced companies to adapt their financial models to compete. Low growth means limited expansion, restricted cash flow, excessive discounting and shrinking profit margins. Debt has allowed many companies that were financially weak to remain open for business in a difficult economic environment.
Many in the financial world were paying attention.
“In minutes of the Federal Open Market Committee’s September meeting, policy makers made explicit for the first time that they’re watching for any hint of risks to financial stability stemming from the more than $1 trillion market for U.S. leveraged loans. They’re late to pile on. There’s been no shortage of warnings from fixed-income traders and credit analysts who track investor protections. Just last month, Bloomberg Opinion Editor Mark Whitehouse wrote a column that called the loans “one likely cause of the next crisis.” The Bank for International Settlements effectively said the same thing a week later. Moody’s Investors Service raised concerns in August. And, perhaps most important, former Fed Chair Janet Yellen said last month that “regulators should sound the alarm.”” (2)
The Fed Minutes stated, “Some participants commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the nonbank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.” (2)
“Moody’s sees grim future for the $1.4 trillion market when the credit cycle turns.” (3)
The “prolonged environment of low growth and low interest rates has been a catalyst for striking changes in nonfinancial corporate credit quality,” Mariarosa Verde, Moody’s senior credit officer, said in a report. “The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives.” (4)
This was before COVID… in the Spring of 2020, the rapid spread of COVID-19 caused caused economies globally to close down in an attempt to slow the spread and reduce the impact on the health system. Shelter in place and work from home (WFH) changed business models, and not everyone was able to adjust.
The unemployment rate spiked and remained elevated throughout the year. Many businesses expanded and extended WFH policies, thereby reducing their need for commercial real estate. Businesses that had previously suffered from poor cash flow found themselves poised on a knifes edge…
Quick action by the Fed led to a variety of programs that psychologically backstopped debt, even for the weakest of corporations. As a result of this policy, all of corporate America went on a borrowing binge… refinancing debt, getting additional cash, finding a way to survive another day. Sadly, the same can not be said for Main Street. According to Bloomberg, 25% of small businesses in America closed permanently. While stock prices hit record highs and corporations have been saved by the Fed, the impact on most of the country has been massively negative… economists have label the binary impact a “K-shaped Recession”.
Delinquency in rent and mortgages is massive. While policy makers imposed an eviction moratorium through the end of 2020, the path forward is not clear at all. The abandonment of commercial and retail real estate, especially in urban centers, has affected cash flow of the debt backing those properties and led to bankruptcies, restructurings, and devaluations. While commercial delinquencies eased in Q4 of 2020, both Fitch and Trapp expect stress and losses to be elevated for several years. (7)
As COVID-19 cases dramatically rise as a 2nd wave brings further restrictions and closures across Europe and throughout the United States the economic outlook is not entirely clear. Markets have embraced optimism as the vaccines are distributed. The challenge is in the economic fundamentals. Even as equity markets hit record highs, corporate profits have substantially declined.
While the Fed reduced the risk in the Spring of a larger economic meltdown, its not clear it has the ability to induce growth in such an environment. Lower or negative rates bring a different set of risks. With many unemployed not able to find permanent work, income inequality continues to build. Expectations of “unlimited free money from the Fed” have reach unreasonable levels.
On Oct 16th 2018 Tom Keene interviewed Mohamed El-Erian on Bloomberg’s Surveillance podcast. Tom Keene asks, “In your book “When Markets Collide” you discuss improved risk management in chapter8… have we? Have we actually improved our risk management? You created this concept of unknown unknowns. Are we better at our unknown unknowns?”
El-Erian answers, “We are not better at our unknown unknowns.“
Tom asks, “We are doing tons of interviews which make it clear there is a new shadow banking. And that’s what people are talking about.”
El-Erian continues, “Correct. Because what people don’t understand is that risk doesn’t disappear, it morphs and migrates. And it has migrated to the non-banks.so there are certain segments I really worry about. I worry about the overpromise of liquidity, that’s now embedded in the system by certain products.”
El-Erian, “I worry about the lower quality segments, segments of high yield, I worry about emerging market corporates. I feel there has been an overpromising of liquidity. When you see the proliferation of ETFs, an inherently liquid asset class, worry. Because what does that ETF signal to the consumer? Instantaneous liquidity at reasonable bid-offer spreads. If the underlying asset class is illiquid that is a silly promise to make. Yet it’s been made because the market has gone that way.” (5)
The challenge for companies with high levels of debt becomes clear when margins shrink and cash flows are reduced. Servicing debt, in such conditions, becomes a major issue for the company and the issuer. Issuers provide long term debt to companies while leveraging short term money. However, if there is insufficient liquidity in the system both parties are punished by markets.
Recently a large and historic retailer filed for bankruptcy when it was unable to pay interest owed on debts. The company has been challenged for years due falling sales, high expenses and the growth of online competition.
From Mohamed El-Erian’s “When Markets Collide”…
“The importance of enhanced risk management cannot be overstated, especially when talking about how best to navigate the journey to the new secular destination… Insights from traditional economics and finance suggest that structural transformations inevitably lead to asymmetrical reactions and challenges the robustness of existing activities and institutions. As such, market failures can and do occur.
Ultimately success in risk management boils down to achieving a single objective through a process that has an appropriate level of predictability, responsiveness, and impact: minimizing the left tail risk—namely reducing one’s vulnerability to the extreme of the distribution that induces intolerable pain…” (6)
Returning to that 2018 conversation with clients, it is clear the financial and economic crisis spawned by COVID-19 will have an impact for years to come. The debt issue has only ballooned to larger massive levels, with even more zombie companies struggling to survive. Could these issues cause another financial crisis? This was an issue that was on many people’s minds these days.
So, what is an investor supposed to do? Work with an advisor to develop strategies designed to reduce and manage risk over the long term. Having a process in place to be aware of risks and manage risks in advance can help investors better deal with the “wall of worry”.
To discuss this issue and others related to retirement and building a sustainable financial future reach out to me at firstname.lastname@example.org
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2021-114049 exp 1/23
- When Markets Collide, by Mohamed El-Erian, pg 265-266