InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
DECEMBER 14 , 2016
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
As expected, The Federal Reserve acted today to raise the federal funds rate by one-quarter of one percent (0.25%), and expects to make similar gradual increases over the coming year. The immediate response from stock markets was a mild selloff, and it remains to be seen if there will be further ramifications in the coming weeks.
This was a rather tepid move by The Fed, and is well short of any sort of normalization in interest rates. But, it was a move in the right direction.
The next major news event will be the vote of the Electoral College, which should put a final exclamation point on an unprecedented election cycle.
In the meantime, we will address a few issues which could prove to be major obstacles for the new President in bolstering the American economy. We refer to stagflation, systemic risk in the banking system, and a credit-default crisis.
Stagflation, a remnant of the 1970s, refers to the combination of a stagnant economy and rising prices. Although not generally considered a threat today, there are elements of it on the horizon. The economy has been growing at an extremely slow rate over the last few years, and three primary measures of economic output are still weak: retail sales, industrial production, and capacity utilization.
At the same time, wholesale prices leapt higher last month. If the next President initiates major federal spending programs, this would likely be inflationary.
As we stated in the November 30 issue of IntelDigest, the reaction of The Federal Reserve will be crucial. If The Fed is “accommodative to massive spending programs and higher federal deficits, we can expect much higher inflation in the near future and exacerbation of the Debt Crisis.”
Inflation without accompanying growth in economic output results in stagflation.
The systemic risk in the banking system has been pushed onto the back burner by most Americans If a new Republican administration makes good on threats to “gut” the Dodd-Frank Act and drastically reduce other banking regulations, the problems of the 2008 Panic will come back to the fore.
The facts are that the banking system is even more dangerous today, the
“too-big-to-fail” banks are bigger than ever, they hold a larger percentage of the total assets of the banking system, and their use of derivatives is greater!
Can anyone doubt that there is still a serious risk of a global liquidity crisis or market panic? Consider some possible triggers of such a crisis:
In addition to a serious natural disaster, one could imagine a few catalysts, starting with the failure of Deutsche Bank. The German bank is undercapitalized and faces Billions of Dollars in fines by U.S. regulators. Its business is interconnected with dozens of other financial institutions, including several in Italy which are facing imminent bankruptcy. And, Deutsche Bank has one of the largest “derivatives books” in the world, making its exposure to danger significant.
We have also discussed manipulations in the Gold market in previous issues. A failure by any institution … Deutsche Bank, for example … to deliver physical Gold on demand would trigger a crisis.
One can also imagine global problems stemming from a Dollar-denominated debt crisis in some emerging markets, or a credit-default crisis in the U.S. We will devote the rest of this issue to the latter.
The Bond Market
In numerous issues of IntelDigest, we have discussed the dangers in the Bond Market: the likelihood that bond values are on their way down, the vast amounts of Debt which many companies have taken on in the low-interest environment of the last eight years, declining corporate liquidity, and the growing risk of default.
U.S. corporations now carry on their balance sheets the highest level of financial risk in our history. Companies took advantage of the historically-low interest rates served up by The Federal Reserve and other central banks, and borrowed unprecedented amounts of money. In every year from 2010 through 2015, U.S. corporations borrowed at least a Trillion Dollars.
Did this borrowing spur growth in the economy? It did not. Many companies used the funds to buy back shares rather than increase capital expenditures, productivity and sales.
Servicing this amount of debt as interest rates rise will be impossible for many companies. The soundness of the corporate bond market has been diminished, so that the threat of default is higher, and potential losses more severe.
Historically, U.S. corporate debt has been predominantly high-grade. However, quality has diminished. During the 2010-2015 buying spree, high-yield (or “junk”) bonds comprised approximately 20% of the issues. This is a much greater percentage of corporate debt than is usual or prudent. The only time this has happened before was in 1997-98, and it ended in disaster when the Dot.Com Bubble burst, leading to defaults in 2001-02.
The default rate on high-yield U.S. corporate bonds rose to more than 5% in August. This has started a new credit-default cycle; some believe that the default rate could rise to 10-15% over the next two-to-three years.
Credit quality of investment-grade debt has also diminished. The lowest quality of investment-grade debt is rated “BBB” … which has increased from a norm of 10% of total investment-grade debt to more than 30% today.
This quality of debt is less likely to default; however, if defaults rise from a normal level of 1% to a level of 3-4%, there will be very large losses at the major financial institutions. Dollar losses on defaults of combined high-yield and investment-grade debt could easily reach into several Hundreds of Billions, which would dwarf the 2008 mortgage loan crisis.
Rising interest rates … inability to service debt … leading to rising defaults … will erase profits entirely in some industries which rely on low interest rates.
As defaults grow, lenders across all industries will become more cautious. Credit will tighten; refinancing will become more expensive for some, impossible for others.
These are the dangers of a Credit-Default Cycle. However, there are possible investment opportunities in this environment.
We have identified sectors which are particularly susceptible to default within the next couple of years … where companies are enduring a fatal combination of falling asset prices, too much debt, and a growing inability to service the debt. We are actively “shorting” several of these companies in our accounts and in client accounts.
Feel free to contact us for more information.