Based on where the yield curve is today, and the fact that the Fed is intending to raise rates to a more normal level (3.5%-4.0% would not be unreasonable) over the coming months, it is time to address potential upcoming vulnerabilities in the credit markets over the next six to nine months. Deficiencies need to be addressed in order to be prepared for what could be a level of market volatility not seen since the liquidity crisis of 2008-9.
Since 2009, US firms have spent $4 trillion on buying back their own stock. This has accounted for 40% of their earnings growth. Since 2012 buybacks have accounted for 72% of earnings growth. JP Morgan is predicting a record amount of corporate buybacks this year worth $800 billion with $171 billion already announced. When corporations buy the dips, volatility in the markets is reduced. Buybacks announced since the tax bill was passed exceed worker increase in wages and bonuses by 63 times. This could be an issue if the Democrats regain the House and Senate in the midterms, as they have already stated that they will use this fact as the main reason why the tax law needs to be changed.
US corporate debt is now at an all time high of $13.7 trillion. This includes debt in very strong, but also mostly some very weak, companies. As cost of debt goes up it is no longer a guarantee that corporate buybacks will offset the turbulence in the markets that will be caused by those with too much debt that cannot survive. In fact, the IMF has recently claimed that 22% of US corporations are at risk of default if interest rates rise. This is even a bigger problem in Europe where junk bonds are trading at very low spreads to their government bonds, and in fact yield the same as US treasuries which is unheard of.
Interestingly, the recent VIX selloff happened during a time when corporate buybacks were mostly in a blackout period. According to Goldman Sachs, they had their busiest week in trading on February 5th as corporations stepped back in to buy their own shares after the blackout was over, stabilizing the market.
Share buybacks cause lower volatility but they also diminish liquidity in the markets which could become a bigger problem with the next prolonged market hiccup. Corporate debt levels will increase as interest rates go higher and could also act as a catalyst to slow down buybacks which have been artificially supporting the markets.
The proliferation of Exchange Traded Funds (ETFs) has meant good companies have been bundled in with bad ones, not unlike the mortgage crisis in 2008 when good mortgages and bad mortgages were packaged in one bundle. As the credit crisis begins, the first step will likely show there is no place to hide. It is reasonable to expect massive selling of all ETFs as the market tries to identify the toxic companies within their ETFs. The good companies will be sold off as much as the bad ones. Good debt will be sold off as much as the bad debt. Furthermore, liquidity tends to dry up in these situations as the professional institutional buyers, and particularly the corporations doing buybacks, step to the sidelines.
The new tax bill benefits mostly high quality companies. Lower quality companies are more levered and will get hit harder according to Moody’s. If interest rate expense to EBTIDA/EBIT rises above the 30% threshold due to any financial deterioration, such as when rates climb, they will actually have to pay higher, not lower taxes.
To conclude, it appears that with a stronger economy comes the inevitable normalization of interest rates. We may well be looking at the end of the bull market in bonds that has lasted more than 30 years. At the very least, it could be a major hiccup. Financial engineering over the past decade would dictate that we are entering a time of extreme caution. There are too many financial instruments that are levered and have not been tested during bad markets, not unlike the Credit Suisse Low Volatility Fund that collapsed a few weeks ago. In times of panic, liquidity disappears but those that need to sell to cover margins or redemptions must sell whatever they can, not just what they would like. This means all asset classes are affected and the good stuff will go down with the bad.
Nevertheless, history has shown us that the good companies without excessive leverage will emerge from any market distortion and will be stronger and better as weaker competitors disappear. The next few months could be crucial for anybody holding any type of financial assets as rates climb higher and valuations must adjust. Only high quality assets should be held, whether in stocks or bonds, and one must also have enough cash to take advantage of the panic selling that will be done by those that were not prepared. At Summerhill we like to say, “a panic sale is our opportunity purchase." We stand ready!
The Summerhill Team