Several years ago, Bloomberg Businessweek did a bio pic on Hank Paulson, Bush’s Treasury secretary who served during the Financial Crisis of 2008. After reviewing the events that led to the Crisis, connecting the dots, and seeing the impact of what happened, Paulson had this to say at the end of the film…
“The whole reason I’m doing this, is not because I want to look back, but because I have increasingly come to the view that it’s important that there be a historical record for those that come after me, so we don’t replay this movie all over again.” (1)
Fast-forward to November 2019, and we saw many positive and negative conditions developing that raised questions about the stock market and the health of the US economy.
Since the summer of 2019 financial conditions have noticeably weakened as the trade war with China has started having a significant economic impact. American and Chinese officials have spoken publicly that progress is being made. Hopes of a trade deal had driven equity markets higher, but as of December 2019 there is still no deal.
The trade war had caused a real decline in business investment and optimism. A CFO survey in the Fall of 2019 showed, “U.S. business optimism dropped this quarter to its lowest level in three years, according to third-quarter results from the Duke University/CFO Global Business Outlook. A majority of CFOs expect a recession to start before the presidential election.” (2)
This lack of business confidence had slowed growth in the economy and motivated the Fed to cut interest rates several times this year. This was all before COVID crippled the economy in the Spring of 2020…
However, even with the slowdown in business optimism and investment, the consumer, which represents 70% of the US economy is still showing strength.
“The first and most important point is that consumer confidence remains high.” (4) Consumer delinquencies continue to fall as wages and hiring remains strong, especially given the new jobs print of 266,000 in December 2019. This number surprised many economists.
However, a simmering problem had been growing over the past few years. Many experts were starting to see the problem as coming to a boil… namely excessive poor-quality corporate debt.
“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.” (5)
Low quality borrowing has greatly expanded over the past 6 years. In an Oct 22, 2019 report, Fitch raised its expectations for default, delinquency and “loans of concern”. (7) When COVID struck the economy in the Spring of 2020, concern over junk debt and the wholesale collapse of weak companies forced the Federal Reserve to create a safety net for credit markets that included the Fed buying “junk debt”. The wisdom of this extreme move was questioned by some.
One positive with all of the liquidity being injected into the markets by the Fed is that debt and credit continues to be available. Rates overall remain low which is helpful for debt servicing.
One fear economists have voiced as the Fed begins the rate hikes in 2022 is the likelihood that credit conditions will tighten. If the economy weakens and credit contracts, many companies that are already weak will find it difficult to access capital. The general effect on the economy in such conditions will be more store closings, more layoffs, and more cost cutting, driving the economy deeper into a recession.
One of the worst performing issuers of debt for the past few years has been debt from oil, gas and coal companies. (9) The shale oil revolution has dramaticly increased oil and natural gas production and driven down energy prices by 50%. Many companies have been issuing debt in order to stay operational. Much of this debt is rated junk due to low cash flow and excessive leverage by ratings agencies like Moody’s and Fitch. (10)
While low energy prices are tough on producers, its extremely beneficial for consumers. Low energy prices allow consumers to spend and support other sectors of the economy.
“Bondholders and other lenders are increasingly wary of what’s unfolding in shale. Chesapeake Energy Corp., once the nation’s largest gas supplier, warned earlier this month it may struggle to avoid bankruptcy.” (3)
In a 2019 report by Fitch, “As the pool of investors willing to lend to coal projects diminishes,” the cost of debt issuance and refinancing rates could be affected “over concerns that other lenders will not be forthcoming.” (6)
In addition, many companies have found the limits on their credit lines cut back during the current round of credit reviews by banks. “The noose is tightening at a time when producers have seen their market values plunge 21% this year (2019). Meanwhile, at least 15 producers have already filed for bankruptcy during the year. A substantive decline in borrowing base can be a good precursor to potential bankruptcy because as capital markets stay closed off for these companies, the borrowing base serves as the only source of liquidity.” (3)
In 2019, Cambell Harvey of the Duke CFO survey gave some great advice. “Executives don’t want to be caught unprepared for the next recession like they were in the global financial crisis. There are plenty of warning signs and now is the time to be prudent. Who wants to put their firm at risk by increasing borrowing to fund a major new project when a recession could be on the horizon? It is no surprise that capital expenditures have dried up.” (2) This is true, and it makes the excessive borrowing over the past few years by weak or zombie companies all the more concerning.
Over the past two years companies have continued to borrow at historic levels. Many companies have used such borrowing to finance dividend payouts and fund share buybacks. (8)
Given the current risks it is important for savers and retirees to work with an advisor to manage risk for retirement savings and other investments.
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- “Hank: 5 years from the brink”