It’s funny how after a relationship ends, it’s so easy to see all of the red flags that popped up along the way. But when you’re in the thick of it those red flags are so easy to overlook. Is it really a red flag that she drops by your office, unannounced, several times a week, and you’ve only been dating a month? Or that she asks you to take her dog for a doggie date so that the two of you can bond? In the moment, these red flags are more a shade of coral because when she’s not acting like One Flew Over the Cuckoo’s Nest, she’s so much damn fun!
However, when the wheels finally come off, you realize your mistake and every single one of those red flags is flashing through your head, in 4K-Ultra Hi Def. This is exactly what happens when investors plow into an asset class that is on the fast track to the moon without paying attention to the red flags. One day they wake up and Glenn Close is boiling their brokerage account in a big pot of rabbit stew. Then and only then are they able to see all of the red flags they ignored. Well my friends, investors right now have a fatal attraction to US corporate bonds and they are ignoring plenty of red flags.
Forecasting is a fool’s errand and looking at data further than a couple of months back is a complete waste of time. Yet, if you watch financial TV or read any type of financial media, everyone is obsessed with looking months into the future or into the past. Paying attention and understanding what is happening right now is how you see the red flags, get an edge over other investors, and most importantly, it’s how you get paid, regardless of how markets behave. Investors look at US corporate debt right now and all they see is a Victoria’s Secret model. They are overlooking a ton of red flags and my suggestion would be to pump the brakes.
Red Flag #1: Leverage
The US corporate bond market has more than doubled in size since the Financial Crisis to just under $6T. Most of this growth was driven by demand from US retail investors in response to the Fed’s early policies after the Crisis. The demand lately has been driven largely by foreign investors trying to escape negative yields elsewhere. The problem with these two investor segments driving demand is that they don’t normally play in the corporate bond sandbox. This means that a slight shift in Fed policy could have both groups running for the doors, and then what?
On top of all of this, US corporations have been propping the US equity market up with records amounts of share buybacks. How do you think they’ve been paying for all these buybacks? Credit baby!
Companies in the S&P 500 have a cash flow deficit of $150B per year because of these share buybacks. This deficit is being funded by the issuance of corporate debt at an increasing pace. I get why this type of activity makes sense given the investor demand and the low rates. The problem is that this level of borrowing can’t continue because measures of debt sustainability, such as the ratio of debt-to-EBITDA, have reached levels never seen before. For instance, the debt-to EBITDA of companies in the S&P 500 has reached the highest level ever, surpassing the previous high made back in 2000.
Is this kind of leverage really a red flag? Is it a red flag if she wants you to meet her family after just 2 weeks?
Red Flag #2: Earnings
This bum rush into corporate debt is also occurring at a time when corporate earnings have declined for 5 straight quarters and the US Dollar is trading at one of the highest levels in six years. The USD has been in a downtrend since December, but it remains at very elevated levels. This will absolutely hurt the international earnings that US corporations have come to rely on. I’m not saying the USD’s impact will be enough to further contract corporate earnings but the USD will continue to have a negative impact on earnings and be a substantial headwind going forward.
Are slowing earnings and a strong US Dollar really a red flag? Is it a red flag when she needs “space” just six weeks into the relationship?
Red Flag #3: Defaults
Investors don’t seem to care about default rates either. Year to date, the US has had as many defaults as all of last year and is defaulting at the same monthly pace as we saw back in 2009, post-Crisis. It’s true that half of those defaults have occurred in the energy space; but still, a default is a default. And the fact that we are seeing a pace of defaults not seen since the aftermath of the Crisis, almost a decade ago, is an extremely important point.
But are defaults really a red flag? Is it a red flag if you’ve been off and on again with the same girl so many times that you’ve spent more time apart than actually in the relationship?
Red Flag #4: US Economy
Just last week, everyone was giddy because the monthly gain in industrial production beat expectations. Trying to derive valuable information by comparing a data point to a group of economists’ “expectations” is like taking a relationship quiz in Cosmo to determine if she is your soul mate. Neither of these things lead to good outcomes. The real value in data is found in the trend of annual growth, and wouldn’t you know it, the annual growth rate of industrial production contracted for an 11th straight month. This is the longest such streak without a US recession. This is happening while we are experiencing the worst slide in US productivity in 40 years!
Is a slowing US economy and recessionary-type data a red flag? Is it a red flag if she invites you over for dinner, eats before you arrive, offers you a box containing 4 Wheat Thins and then eats two of them?
Earning are declining and defaults are rising against a back drop of a deteriorating, and possibly recessionary, economic landscape. Does this sound conducive to snatching up all the US corporate debt you can handle? This is a relationship destined to end with someone refusing to give back the other person’s favorite sweatshirt.
The Investors buying up assets and ignoring these red flags will end up looking like the guy from “Seven” who was forced to eat himself to death. Gluttony is not a good look.
But can you honestly blame these guys? Central bankers have manipulated markets to the point that they all look like California Dimes, none more so than US corporate debt. And they are actively encouraging us to ignore the red flags.
Globally, central banks have done about as much as they can do. What’s really left in the old toolkit? We have no economic growth and yet we’ve got asset bubbles all over the place.
People are continuing to pile into stocks because of the belief that central bankers will continue to do whatever it takes. Investors don’t care if central bankers making it rain in the financial market strip club hasn’t helped the global economy, because it has inflated asset prices.
And now we have people piling into bonds, along the entire quality spectrum, hoping to lock in a positive yield before that becomes a unicorn, consequences be damn. It’s like in my younger days, when I knowingly made a bad decision but simply thought to myself, “That’s Future Landon’s problem, not mine.” This is what is happening right now on a global scale from individual investors all the way up the food chain to institutions, sovereign wealth funds and central banks.
Verse 23 in the Tao Te Ching says “Fierce winds do not last all morning. A downpour of rain does not last all day. But these are exaggerated, forced effects, and that is why they cannot sustain.” Exaggerated, forced effects, is a pretty damn good description of the central banking experiment that has been going on for the last 8 years.
Lao Tzu says its unsustainable and I agree.
I’ve traded markets long enough to know that by better understanding what is happening right now, the markets will provide me with plenty of red flags before the train comes completely off the tracks.
There were red flags back in 1999-2000 and again in 2006-2007, this time won’t be any different. The majority of investors will miss the red flags or only see flags of coral because they’ll be enamored with the seemingly easy money that is being made.
Mark my words, these same investors will be wearing their shock and awe faces when this whole thing unravels and takes trillions of dollars in wealth with it. Do yourself a favor, make it a habit to pay attention to what’s happening right now as part of your investing process. That way you’ll never have to wear your shock and awe face when you see your account value.