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Pushing On A String
Back in the early 90s, global interest long-term rates - as measured by our IRS index, weighted for outstanding global OTC positions and adjusted into USD - were in excess of 10% as the UK attempted to cool the Lawson Boom, the
Bundesbank was making Helmut Kohl pay for his 1 Ost = 1 West decision,
Greenspan was pricking the latest debt bubble in the US and Mieno was
all-too successfully restoring sanity to Japanese asset markets.
Rates then halved as the ERM crumbled, Japan imploded and America's banks began to domino. Soon, however, bust began to turn again to boom, and it was time to lurch onto the other side of the boat in an attempt to keep it from capsizing under the weight of its own contradictions. The Fed's 1994
tightening - and the associated leveraged and structured derivative cascade
- took us screeching back over 8% before Mexico collapsed and Japan begun to pump dangerous amounts of liquidity into the system in order to reverse the
Yen's debilitating rise.
Then the Bubble began in earnest and interest rates embarked upon a fairly
uninterrupted decline to their nadir of 3.8% in the early Spring of last year. Not only was this unprecedentedly low, for the modern age at least, but it represented a global zero real rate if we compare it to OECD composite indices and it came at a time when the ability to manufacture credit had received an enormous (and still only dimly-understood) fillip from the launch of the Euro and the consequent consolidation of European banking and capital markets. See the chart at www.capitalinsight.co.uk for illustration.
As the monetary inflation combined with the advent of mass-media, real-time
capitalism via Cable TV and the Internet, millennial thoughts of the triumph
of technology over Nature and irresponsible endorsement of its possibilities
from central bankers, principally Greenspan, stock markets began to surge
and a dangerous combination of asset-based loans and 'enterprise' lending
took hold. Often this was exacerbated by the fact that many credit-scoring
models plug in market capitalization rather than book value. With the
price-to-book exploding from 3 to over 7 on the S&P500 (and into the
stratosphere for the New Era sector), an awful lot of air was left between the liquidation value and the going-concern basis of the companies raising this finance.
Meanwhile, the seemingly effortless route to market and the artificially
depressed cost of equity capital gave lenders even more comfort that their
debtors would find other pockets to pick before things turned sour. Consumers, bombarded by offers of ready finance, often bound up in
innovative ways against their financial or real estate assets, were only too
quick to oblige, so that the economic patient's dangerously high temperature
was seen more as the healthy flush of an athlete in full stride.
Credit Bubbles always end badly and the fact that they inevitably grow much
faster than people's ability to pay, or hard assets' ability to sweat, means that there comes a point when the amount of credit merely being raised to service previously contracted indebtedness becomes such a burden that only truly hyperinflationary amounts of money injection can keep the process going. We now start feeding stimulants to a cardiac arrest case.
The bond market has come to price this in over the course of the summer as
the growing wave of defaults and downgrades has led credit analysts to cast
a jaundiced eye over the work of their colleagues who job it is to tout stocks (sorry, perform equity analysis).
The Western economy has barely begun to slow and was still being driven by
consumer borrowing at what, a few short years ago, would have been an
enviable pace, according to the last reports. Yet, despite this, risk spreads have exploded back to levels not seen since the early 90s credit crunch. Perhaps with reason.
Diane Vazza, head of global fixed income research at S&P was quoted in the
NY Times recently saying "We are now in the 10th consecutive quarter where
we have seen downgrades of corporate debt outpace upgrades. The last time we saw that was in 1990-1991, when we had 11 consecutive quarters of downgrades during a period of record defaults." Indeed, as she went on to note, the recession's height in 1991 saw total US defaults of $19.7 billion: so far this year, we have already exceeded that by a quarter.
Moreover, as Fitch IBCA pointed out, backing up findings contained in recent
FDIC/OCC reports, defaults are occurring with alarming frequency on debt
raised in the last two to three years. In other words, companies who raised
funds during the Panic loosening of monetary policy between the Asian crisis
and LTCM's demise are failing. Austrians, arise! Pumping money in to stave off a credit collapse only perpetuates the rash of bad business decisions
occasioned by the previous monetary inflation and even encourages more
malinvestment to occur.
Worryingly, we have to think about what will become of the monies raised in
the Y2k Hoax and the stock market's ballistic phase in the Winter of 1999/00. The precedents suggest that even more poor decisions were made by
star-struck borrowers and aggressive lenders, both, and that there is even less salvageable collateral to be had when these guys hit the canvas.
Again, there is evidence to support this contention already. Fitch cites research that between 1991 and 1997, defaulted debt realized around 40 cents on the dollar when the dust had settled: the last three years has seen that decline precipitously to 32 cents. Put that in your risk:reward pipe and smoke it.
What is worrying is that broad equity indices the West have only gone
sideways, rather than down, this year and, even allowing for the unfolding
calamity in Asian stocks and the near-collapse of most minor currencies
around the world, the MSCI World index is still over double what it was when
this all began in 1995. Adjustment has not yet been comprehensive here, by
any means.
Moreover, central banks have dangerously reduced room for manoeuvre,
especially as consumer prices feel the pressure in typical late-cycle fashion. Not only are government bonds only some 50 or 60 bps over recent historic lows (using the JPM global index), but our OTC index - which is effectively a double-AA style measure - is also only 80bps or so above its least, despite spread widening driven by the Great Inflation's effects in government balances, together with the first signs of infection leaching up from the toxic pits of junk.
If government bonds and their financial sector, high-end counterparts are
already at levels we have only barely touched in the last thirty years and
macro-statistics are merely easing off the climb, rather than beginning a
dive, how much leeway do the BIS helmsmen have when the wind starts blowing in earnest onto the rocky shores of recession? How quickly will they steer with crude potentially breasting $40 over the winter?
The Big Names on Wall Street have been out rallying the troops for another
buying surge in the last week or so. We remain highly skeptical. Bonds do look expensive against oil, against measured current cost of living indices and against short rates - horribly so for US Treasuries on that last count. However, they are still cheap to stocks and very divergent in their outlook. Carry may be highly negative in the Us, negligible in other major markets, but it sure beats a dividend yield and while a profits warning costs you 25% in an afternoon on your equity, it only lops a couple of points at most (in the first move) off your debt holdings in the same enterprise.
The inference should be obvious.
Stock analysts tell us they see the glimmer of dawn against the darkling
skies: Let's just hope it's not the flare from a comet on collision course.
Sean Corrigan
Capital Insight
22 November 2000
