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bonds, bottom-line, budget deficits, central banks, correction, debt, Federal Reserve, Financial Crisis, financial markets, Great Recession, interest rates, leverage, monetary policy, profits, stocks, tax cuts, top-line, {What's Left of) Our Economy
Heckuva week on the world’s financial markets, eh? This post isn’t intended to provide any investment advice, but rather to shed some light on what strikes me as the most interesting question posed by the stock market correction and the related spike in bond yields: Why is it happening as evidence keeps emerging that the world economy (including America’s) is entering its best stretch of growth since the last (Great) recession ended in mid-2009?
Right off the bat, in the interests of full disclosure, the vast majority of my investments are in bonds (mainly munis) and bond proxies (high-dividend stocks whose share prices are relatively stable, so that their main value is spinning off income). This means that my main hope is that bonds keep doing well (notwithstanding their recent slump).
That said, it seems clear to me that the answer is that investors are worried that the stronger growth seen globally isn’t sustainable. Indeed they seem fearful that it’s about to come to an ugly end because the world’s central banks look more determined than in many years to at least limit the easy money conditions they created to fight the financial crisis (and ensuing recession), and to try to spark something of a recovery.
This kind of monetary policy tightening – or even a further slowdown in or halt to the loosening, which is what’s most likely in the near future – could create a pair of closely connected economic and financial dangers. First, slower growth could imperil the sales and profits of companies that issue stocks, which could depress their prices. And P.S.: Despite the record central bank stimulus, growth has been unimpressive enough. How much tightening is needed to tip the economy back into recession?
Of course, businesses all around the world have performed magnificently in boosting profits in a slow-growth environment, and this also goes for non-financial companies that haven’t been able to enjoy the full benefits of borrowing from central banks at super-cheap rates and lending at higher rates. But precisely because growth even during the recovery’s best periods so far has been sluggish despite the gargantuan stimulus, much of the profit improvement has come from improvements in the bottom line, keyed by cost-cutting (including keeping the lid on employee paychecks). Top-line growth – that is, stronger sales of products and services – has been more difficult to come by.
Since costs can’t be cut completely, and possibly not much further, a growth slowdown could greatly reduce these firms’ potential to increase profits going forward, and turn them into much less attractive buys for investors. And tighter monetary policy, including raising interest rates, historically has been pretty effective at slowing growth.
Just as important, low interest rates per se have super-charged stock prices. The reason? They greatly depress the total return on bonds, and thus greatly boost the appeal of stocks.
Of course, this raises the question of why central banks would take such actions, or even think (out loud) about them. The reasons are that they’re worried that all this easy money will ignite a new round of dangerous inflation, and that they’re concerned that, because money has been so cheap for so long, borrowing consequently so easy, and mistakes therefore so easy to withstand, too much capital has been poured into risky investments. Central bankers are rightly concerned that this “mal-investment” eventually could imperil the entire financial system and hence the real economy just as it did during the previous decade. So they’re hoping they can wean the world off this sugary diet.
The challenge they face is making sure “the patient survives,” or doesn’t become gravely ill again. After all, the previous decade’s financial crisis showed that when dubious investments reach a certain level, creditors can start doubting borrowers’ ability to repay or even service their debt even when the cost of money is very low. When they start to pull in their bets, panic can easily set in – and did.
These dangers become much greater when the cost of money starts to rise, which is exactly the situation the nation and world are in now. Just one indication of heavily indebted businesses are: According to Standard & Poor’s, one of the financial ratings agencies, in 2007 (just before the global bubble burst), 32 percent of the world’s non-financial companies were “highly leveraged” (i.e., up to their ears in debt). The latest figure? Thirty seven percent.
This corporate debt, of course, is relatively easy to service and manage when interest rates are very low. In a higher rate environment? Not so much. And don’t think creditors don’t know this. So that’s another reason that companies could start looking less appealing to investors, and if major debt servicing (much less repayment) problems emerge, credit channels could start seizing up just as they did ten years ago. On top of this prospect, all else equal, rising rates tend to be trouble for stock prices, as more and more investors decide to opt for (higher) guaranteed returns on bonds rather than riskier equities.
P.S. If you’re wondering whether higher rates could significantly increase the debt burden on the U.S. government, even without the immense new borrowing that will be needed thanks to the Trump administration’s tax cuts and the new big-spending Congressional budget compromise, the answer is, “You bet!”
Not that reasons for optimism about stocks in particular can’t be identified. Because the big ramp up in federal budget deficits that’s on the way will inject massive new resources into the economy, more growth will result. In principle, that new growth could convince the Federal Reserve to speed up its tightening – but perhaps not enough to offset the fiscal boost. Moreover, anyone who’s positive that the Fed will keep tightening in the face of either future stock market turbulence and/or weaker economic growth hasn’t been paying attention to its record in recent decades. The central bank has been, in the view of many, all too willing to keep the economic party going at all costs, and may well do so again.
One more bullish possibility for stocks – as they did during the previous decade, the leaders of stock-issuing companies decide to use most of their tax cut windfall to buy more shares of their own stock. The result would not only would prop up the share price, but in many cases boost their own compensation (which not so coincidentally is often based on that share price).
The most vexing aspect of both the investment and the economic situation is that, even though both may suffer in the short run, both urgently need to end their addiction to central bank stimulus and create the kind of foundation that will promote healthier, and thus longer-lasting (even if not faster) growth. Moreover, the longer the addiction lasts, the worse the cold turkey experience.
Because I doubt that either the Federal Reserve or the rest of the U.S. government has the spine to administer the needed policy medicine, I remain pretty bearish long-term on both the markets and the real economy, and will stay very conservatively invested. But the short term can be surprisingly long lasting; in fact, I’m surprised that the Fed’s high wire act has lasted this long. So I’m anything but an infallible guide to either. I’m just trying to be prepared for major trouble – whenever it decides to arrive.
RealityChek 