A Journey Below the Surface: Swimming with Zombies & Fallen Angels

Sune Hojgaard Sorensen, Director of Macro Research

Thought No. 1: Swimming with zombies and fallen angels…

There is an old adage that states; “When the wind of change blows in some seek shelter while others build windmills.” As an investor it pays to be able to do both. In fact, managing wealth – when done correctly – is a perpetual endeavor. Hence flexibility and an all-weather approach is optimal. In the words of Darwin; “It is not the strongest of the species that survives, nor the most intelligent. It is the one that is most adaptable to change.” 

 We are living in a period of rapid change currently – socially and economically – and the 2020s looks to be a decade with multiple tipping points cascading into a prolonged state of flux. The onset of the Covid19 health crisis in late 2019 has escalated into a full-blown global economic crisis as policy makers pulled the breaks on the real economy and prevailing social norms – bringing the ‘patient’ into a precautionary coma. We have since then seen various incoherent attempts at resuscitations at national levels. The medication administered so far has been fiscal and monetary stimuli at increasing levels via more and more arcane conduits. The results have been mixed. Predictably asset prices, especially in the US, has seen a real pop, but the real economy was already struggling coming into 2020 due to long term issues and all the problems has been fast tracked and driven to the forefront. Governance is at best distracted with the many immediate problems or at worst in such a state of extreme partisanship that strategic planning and implementation is impossible.

So far this year the US stock markets dropped from record highs to bear market territory in just 14 days. That was the fastest time between a new high and a bear market in history. The prior record was 42 days and it was set in 1929. Any student of financial history will know that breaking records set in and around 1929 is not great. This has since been followed with a nosebleed inducing snap back to break those recent highs as the combined liquidity injections of both unprecedented monetary and fiscal measures took hold. If one just lived on an intellectual diet of mainstream financial media one could easily be left feeling that all is well, and prosperity is on the up and up. The stormy waters have been calmed with rich applications of monetary and fiscal ‘oil’. However, if one dares peek below the surface, one is left with a more nuanced and murky set of perspectives.

Below the calm surface of the oceans of debt, zombies and fallen angels roam…

On the current trajectory global GDP is not set recover to pre-Covid19 levels until 2022 at the earliest. Global trade is down 18.3% y-o-y. Global debt rose to $258trln in Q1 of 2020, or a record 331% of the world’s GDP and according to Bloomberg developed economies have $3.7trln of debt coming due through yearend. The public debt in OECD countries is set to top 137% of GDP this year. The Fed’s balance sheet has gone vertical and currently sits at + $7trln, earlier this year it bought $1.3trln of US government debt in a 5-week period. US non-financial debt totaled $6.6trln at the end of 2019, a 78% increase since mid-2009 and in Q1 2020 alone a further $754.9bln has been added. With the real economy in dire straits, ‘zombies’ and ‘fallen angles’ are popping up everywhere. A ‘fallen angel’ is a bond that was rated investment grade but has since been downgraded to ‘junk‘ status due to the declining financial position of the issuer. In Q1 more than half of all US corporate bonds were classified as ‘junk’ and an additional 30% was hovering one notch above.

Much of the corporate credit boom has been driven by the perpetually rising requirements of the PE industry to lever up and refinance their bulging portfolios. Private credit including Leveraged Loans and CLOs now reach into the trillions. Earlier this year, as these giant sandcastles started to feel the effects of the tide, the Fed had to swoop in and on March 22 2020 it established the ‘Secondary Market Corporate Credit Facility’ (SMCCF) which comes with a dual approach to inject billions (so far) into a wide range of US companies. The ‘Corporate bond purchase program’ has the ability to purchase corporate bonds from an index of nearly 800 companies, including companies drifting into junk status. The second arm, the ‘Exchange-traded fund (ETF) purchase program’ enabled the Fed, for the first time in history, to directly purchase billions in corporate bond ETFs. Just the announcement of these measures where enough (for now) to bring those pesky rates back to the basement level they have been occupying for the last decade and in doing so enabling struggling corporates to continue their debt fueled trajectory.

Looking at US corporate earnings it is difficult to see how they will ever be able to pay off these debts or even service them. In Q2 US corporate earnings dropped y-o-y an average of 100% for SMEs and 35% for large corporations. Coming into 2020 40% of listed US small cap companies had been reporting a loss for at least the last 3 years and over 10% of large cap companies were the same. Around 20% of US companies met the BIS definition of a ‘Zombie firm’ i.e. “a firm that is unable to cover debt servicing costs from current profits over an extended period”. Hospitality and energy were hardest hit, and we are currently seeing the ramifications in the CRE space with CMBS loan delinquencies for the hotel and retail segments touch the previous highs from back in the dark days of 2010. Central Banks can ‘print’ liquidity, but solvency is another matter.

Welcome to the 2020s, best come prepared for some real change…

Beyond the monetary efforts, governments have been busy on the fiscal side. A Q1 study by McKinsey forecasted that Covid19 economic crisis could drag on until 2023 and that in dealing with it, governments around the world would have to take fiscal measures that could translate into an unprecedented cumulative fiscal deficit of up to $30trln – equivalent to 30% of global GDP. When it’s all said and done this number may turn out to be on the low side. The global economic, financial and geopolitical systems of the last 7 decades are all in flux with no real clear outcomes in view. The US, the driving global power, finds itself in the worst governance climate since the turmoil of the late 1960s/early 1970s. Rolling social unrest driven by deep rooted issues has set in with no real solutions in sight. The answer in the 1970s was to throw money at the problems with the ‘guns vs. butter debate’ turning into an embrace of the ‘guns and butter’ policy framework that has been with us since. This meant a breakdown of the global currency system, as President Nixon had to abandon the post WWII Bretton Woods framework and remove the USD from the its last linkages to gold. The low inflation of the 1960s quickly gave way to surging double digit inflation rates.

In the last decade global monetary policy has been loose but fiscal policy relatively tight. The last couple of years in the US has been the exception, with tax cuts and fiscal spending combined with relatively tighter monetary policy. Now both have been unleashed in the face of the Covid19 Crisis. Fiscal spending is politically hard to scale back let alone stop once you get started, and as we have seen that once monetary policy gets going and becomes a key driver of asset prices that also becomes impossible to rein in.

The risk going forward is that there is a sense of ‘the boy who cried wolf’ attached to inflation risk after many observers made strongly worded predictions for high- to hyper-inflation being just around the corner when those first rounds of QE were unleashed back in ‘08. Populations seeking simple painless solutions to complex difficult issues tend to find politicians who will make promises of exactly that. The ‘answer’ would appear to be ‘MMT’ by another name with never ending ‘temporary’ fiscal programs paid for by more and more debt which in turn is bought by the Central Bank spiced up with some ‘tax the rich’ efforts as a token measure towards fiscal responsibility.

Will we see a similar path taken to that in the early 1970s in the US? The ingredients are all there, what will be cooked up for us to digest remains to be seen. What is for sure is that most Central Banks have lost their independence and are increasingly a tool for government policy and with global levels of debt reaching new records every quarter, it will be very painful to raise interest rates and any policy errors will be felt far and wide. Monetary and fiscal policy is on a glidepath to merging. We are heading from a relatively fixed environment into flux. Major change tends to reverberate and spread with unpredictable consequences. Liquidity driven markets, increasingly untethered from the real economy, makes a for a volatile reality. What was will no longer be. It has been well said that; “Eventually passive investing will turn into active panic.” The environment we are heading into will no longer be so welcoming to the passive ‘long only’ herd. Getting active and staying flexible will be key. Daring to be different will bring an edge.

Surveying the world’s financial asset markets today an article called, ‘The Black swan of Cairo’, by NN Taleb and his co-writer Mr. Blyth springs to mind. In it they eloquently state; “Complex system that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface.” At Strategic we see plenty of opportunity both on the long and short side, but effective risk management and creative ways to harness the ‘storm’ will be the key to navigate these treacherous waters. It’s clearly time for an all-weather approach.

For a private conversation on these dynamics and how the Strategic team looks to navigate them for optimal outcomes, please feel free to reach out to us via sune@thestrategicfunds.com.pr

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