In the Fall of 2021, the economy continues to slow, and it is having an effect on markets.
I wrote this article originally just before COVID hit… some of the observations were in 2019, as you will see.
In 2019, the economy was already slowing…
It is interesting how the comments in the original article are appropriate for today’s economic environment.
In 2019, incoming ECB President Christine Lagarde stated the US trade war with China had “dented global economic growth.”
“You can’t adjust to the unknown. So, what do you do? You build buffers. You build savings. You wonder what comes next. That’s not propitious to economic development,” said Lagarde.
“It means less investment, less jobs, more unemployment, reduced growth. So of course, it has an impact,” she said. Lagarde led the International Monetary Fund for 8 years prior to moving on to the ECB. (1)
Recent surveys by the NFIB strike a similar note by US businesses that in 2021 are constrained by supply chain delays, increasing prices, and labor difficulties. (2)
“Small business owners are doing their best to meet the needs of customers, but are unable to hire workers or receive the needed supplies and inventories,” said NFIB Chief Economist Bill Dunkleburg. “The outlook for economic policy is not encouraging to owners, as lawmakers shift to talks about tax increases and additional regulations.”
The NFIB report continues, “Plans to make capital investments are depressed as the outlook for business conditions in the future are not very positive. Owners are clearly trying to hire but are not being very successful in spite of paying higher wages. In the meantime, inflation is squeezing profits (the major source of operating capital for small firms) so firms are raising selling prices.”
A slowing US and global economy is bad news for many companies that are highly leveraged and the debt markets they rely upon.
The following headline appeared on Bloomberg news in 2019… “Leveraged Loan Buyers Are Running for Cover as Fear Ramps Up.” (3)
“Simply put, money managers are flocking into debt with higher credit ratings because they’re worried about how riskier securities will hold up if economic growth slows and their weak investor protections are put to the test. Already, big price moves are roiling certain pockets of the credit markets with greater frequency. That’s pushed the gap between prices on single-B and double-B rated leveraged loans, as well as the spread between triple-C and double-B junk bond yields, to the widest levels since mid-2016.”
Many corporations with poor financials (lack of revenue, poor sales, no growth) in the US and Europe have been borrowing money over the past 7 years at historically low interest rates. Such companies have relied on cheap debt to remain in operation. In 2021, leveraged loans reached the highest levels on record as more companies are accumulating cash to pay rising dividends.
A recent WSJ article pointed to record issuance of speculative grade loans to finance dividends hit $72 billion in 2021. This is not prudent corporate behavior. (4) “The record marks one sign companies are becoming more comfortable with their cash-stuffed balance sheets and the economy’s trajectory, analysts said. Leveraged loans are typically issued by companies with significant debt relative to their earnings, making them more sensitive to the economy’s trajectory.”
Issues around debt sustainability have become more elevated with the unfolding financial crisis in China generated by the default of Evergrande and other Chinese real estate firms. As a result, credit markets have begun to tighten. Steven Van Metre, CFP with Atlantic Financial, stated “keep in mind… what if the economy rolls over? If the economy rolls over these companies are going to have a massive problem with their debt.”
S&P Global Ratings released a report in 2019 with the title “Weakest Links Reach a 10-Year High.” S&P defines weakest links as issuers rated B- or lower with negative outlooks or on its CreditWatch with negative implications. There were 263 of them globally in September, the most since November 2009. “The default rate of weakest links is nearly eight times greater” than the broad junk-bond market, analysts Nicole Serino and Sudeep Kash wrote. “The rise in the weakest links tally may signify higher default rates ahead.” (5)
Fed policies during COVID put a floor under the high yield and junk bond market. As a result, companies issued debt in vast quantities at historically low rates. Corporate fundamentals ceased to matter to markets during this time. This greatly increased the overall level of indebtedness among lower rated companies.
The S&P report in 2019 concluded that “if there’s even a chance that corporate failures exceed estimates, bondholders aren’t the types to stick around and risk it.” Such a situation could affect liquidity in the market and lead to contagion. Now, in 2021, the Fed appears committed to pulling back on Quantitative Easing (QE) as the economy slows, and this may be an issue…
Oaktree Capital Group LLC’s co-founder, Howard Marks, for one, is skeptical that the Fed can hold off an eventual recession. He said in 2019 that his firm, one of the world’s largest distressed-debt investors, has gradually been putting more emphasis on safety in credit, though he’s still comfortable holding single-B rated obligations that his analysts have vetted. “Ratings don’t tell you whether something is safe or not,” he said. “We have over time increased our demand for safety.” (6)
In a 2019 interview on Bloomberg, Marks said negative interest rates may be making people scared. “They cause people to see a future that is negative, and they send that signal. The savings rate has gone up in Europe and people are hoarding (cash)… sometimes you can’t get people to spend money.” He continues, “I believe negative rates come from a lack of economic activity… a growthless future.” Negative real rates persisted throughout 2020 and into 2021.
In a 2021 interview, Marks discussed the impact that Fed policies had on credit markets in 2020. He said, “There’s a great quote by Benjamin Graham who is the coauthor of ‘Security Analysis’ and was Warren Buffet’s teacher at Columbia. Graham said, ‘in the long run the market is a weighing machine, but in the short run it’s a voting machine.’ What he meant was that eventually the market figures out what something is worth and moves the price, and that’s what leads to appreciation or depreciation in the long term. But in the short run it’s a voting machine which is to say in the short run the market reflects popularity.And if you want to win in investments you have to figure out which investments are going to gain in popularity. Our goal as long term investors is to figure out value… we want to do the weighing earlier and better, and we trust the market will catch up to us and our conclusions if they are right, and will move the price of the investment to where we think it should be…
In the short run it’s a voting machine, but its tough to predict popularity. As an investor we are looking at the fundamentals. We should all be weighing machines, we should all be thinking long term.”
We are facing a great deal of uncertainty in the Fall of 2021…
Fed changing policy…
Political conflicts affecting fiscal policy…
Labor concerns and rising inflation…
Slowing economy and worsening consumer confidence…
Liquidity concerns due to Evergrande and China’s real estate troubles…
Such economic conditions create a challenge for retirees and savers. Managing risk is key to navigate your financial ship to a secure financial future. Working with an advisor who understands your specific circumstances and how the economy will affect your options.
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- The Memo by Howard Marks, What does the market know?