MorningWord 12/9/15: Revolving Credit

by Dan December 9, 2015 9:42 am • Commentary

I think it’s fair to say that most of the volatility (up and down) in global equity markets over the last twenty years has resulted from investment bubbles created, fueled and then mismanaged by easy monetary policies. That has led to a series of deleveraging periods, the most recent posing systemic risk to the global financial system.

The financial crisis that started here in the U.S. in 2007 has for all intents and purposes been a rolling debt crisis for the rest of the world.  By the time U.S. households and financial institutions dramatically reduced their leverage in 2010/2011, European nations then faced default as years of debt fueled development were met by low growth and the economic inequities between the disparate nations joined in an imperfect union.  The jury is still out on whether or not Europe is out of the woods, but there is a large degree of certainty that the commodity crash of the last year and a half is a direct result of (what some are calling) the third wave of the financial crisis, now hitting emerging markets and further suppressing global growth.

To combat the first wave the U.S. Federal Reserve went nuclear. Despite that, after 7 years of unprecedented monetary policy we are still faced with 2% growth and deflationary pressures all around.

For the second wave, the ECB head Mario Draghi adamantly stated that he would do “whatever it takes” to keep the union together, and its nations solvent, taking a page out o the U.S. Fed’s too big to fail playbook.

And now we have the third wave and a new problem. As global growth has been suppressed by an emerging markets debt crisis driven by the collapse in commodity prices, it happens to coincide with the U.S. Federal Reserve’s wind-down of Quantitative Easing (last year), and the likely end to their Zero Interest Rate Policy in this month with the FOMC’s first rate increase since June 2006.

An article in Bloomberg this morning (As Fed prepares liftoff, emerging markets face record bond debt) adequately sums up the potential for credit issues in emerging markets to dramatically increase risk asset volatility in 2016, emphasis mine::

Developing nations are facing their biggest debt bills yet from international bond markets that funded them in boom times. It’s happening just as the cost to refinance overseas creeps higher, with money manager Pioneer Investments seeing no relief in sight.

Companies and governments in developing nations must repay an unprecedented US$262 billion of notes in all currencies outside domestic markets in 2016, more than half the US$444 billion they sold this year, data compiled by Bloomberg show. The bond tab will rise further in 2017 to US$352 billion. The borrowers missed payment on US$5.6 billion of the debt this year, the most since 2002.

And one of the largest trouble spots is obliviously Brazil, as Bloomberg summed up last month (Petrobras’s Dangerous Debt Math: $24 Billion Owed in 24 Months), emphasis mine:

That’s a towering hurdle for a company that hasn’t generated free cash flow for eight years and whose borrowing rates are soaring. Annual debt servicing costs have doubled to 20.3 billion reais ($5.4 billion) in the past three years.

The delicate task of managing the massive $128 billion mound of debt accumulated by Petroleo Brasileiro SA — 84 percent of it in foreign currencies

And from the Wall Street Journal on Monday, The Stock Market Is Missing the Warning From Junk:

Junk bonds are headed for their first annual loss since the credit crisis

The junk-bond default rate rose to 2.6% from 2.1% this year and will likely jump to 4.3% in 2016, breaching the 30-year average of 3.8% for the first time since 2009

Corporate mergers and acquisitions—often funded with junk bonds—hit record levels this year, while the ratio of high-yield debt to corporate earnings is approaching an all-time high.

We are now seeing distressed oil companies and industrial metal mining companies dramatically cutting costs and slashing dividends (Anglo American, Freeport McMoran and Kinder Morgan to name just a few this week) in an effort to stave off coming defaults. And I haven’t even mentioned what was the poster-child (this summer) for impending commodity doom, Glencore Plc ($17 billion market cap, $50 billion in debt, the mining and trading company, which is now approaching the September lows, down 72% on the year.

It may not seem like it at times in the U.S. equity market, but it’s a mess out there. It’s not all that different than the lead up to the burst of the housing bubble in 2007. I think it’s important to note that the S&P 500 closed up 5.5% that year, a year that (like 2015) traded for the better part of the year in a bout a 10% range, with a close near the midpoint:

SPX 2007 chart from Bloomberg
SPX 2007 chart from Bloomberg

In 2007 and early 2008, the powers that be, specifically The Fed and the financial institutions that were on the hook for housing related debt repeatedly claimed that whatever crisis was emerging was contained.  It seems to me that the set up is fairly similar as is the message from those with the most to lose from a nasty unwind of this third wave of the rolling debt crisis.  Those who casually dismiss a mere 25 bps increase of Fed Funds rate as a non-event, are talking out of the asses as none of us really has any idea the spark it could ignite in what is already a rolling credit crisis in emerging markets.