InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
JUNE 13, 2018
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.
We have written, at length, on near-term prospects for The Economy and Markets in Spring issues of IntelDigest. We remain substantially invested in equities, expecting one final upward lurch in this nine-year-old Bull Market.
We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August … trying to sell into strength by mid-Summer.
It is important to distinguish between the near-term period, which should last through most of 2018, and the recessionary period beginning in 2019. The next three months will likely be the last opportunity for growth in equities for the next several years. So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.
And, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years. Perhaps, stagnation will roll into a return of the Stagflation of the 1970s … especially if political pressure is applied.
As we have written, the recession is inevitable, not imminent.
Looking Ahead
In recent weeks, we have moved forward to discussions of our Look Ahead at the Economy-To-Come … planning for the transition from this Bull Market to leaner times ahead. We replayed our February 21 discourse on Inflation, Interest Rates, and Volatility; then, moved on to the prospects for Stagflation; and, reviewed the prudent approach to investing in a coming Bear Market.
We will discuss Credit Cycles today; next week, we dive into the role of Debt … Government Debt and Deficits, Corporate Debt, Credit Card Debt, Student Loan Debt, Auto Loan Debt … in the Unraveling to come.
Credit Cycles
A seminal transformation in world economies has been occurring over the last 20 years, and right under our noses. In essence, we no longer have old-fashioned business or economic cycles.
We now have Credit Cycles, which ebb and flow with monetary policy.
When the Federal Reserve (The Fed) cuts short-term interest rates drastically, the only purpose is encouraging Americans to borrow a lot of money. When The Fed reverses its policy and raises rates … thereby reducing liquidity … The Fed is discouraging us from taking on more debt.
This modus operandi goes back to the 1990s, when The Fed, under the leadership of Alan Greenspan, heavily promoted interest rates which were abnormally low at the time, even though the then-booming economy needed no stimulus. This policy was attributed to the need for liquidity as we approached the potential crisis of Y2K, and a response to market turmoil following the near-collapse of the Long Term Capital Management hedge fund.
Again, in the early 2000s, The Fed loosened credit, which contributed to the 2008 mortgage crisis and the Great Recession.
So, for over 20 years now, companies and individuals have learned from The Fed that running up debt is easy and fun! But, over time, debt stops stimulating growth. As debt accumulates, every additional point of GDP growth requires greater and greater amounts of debt.
Debt eventually becomes a drag on growth. When growth is dependent on added debt, growth “borrows” from the future; in other words, debt-induced growth pulls spending forward, reducing a future recovery.
Debt also artificially boosts asset prices. Stocks and real estate have done extremely well in an era of ultra-low interest rates. But, as rates rise over the next couple of years, and The Fed continues to unload Billions of Dollars of assets from its balance sheet, the values of stocks and real estate become vulnerable.
The value of an asset depends solely on the willing buyer. As financing costs for future buyers go higher and higher, inflated asset prices will recede.
Recessions
In the good old days of the economic cycle, recessions triggered bear markets. Economic contraction slowed consumer spending, corporate earnings fell, and stock prices dropped.
Things are different in the Credit Cycle. Lower asset prices are not the result of a recession … they cause the recession, because access to credit drives consumer spending and business investment. When you take it away, Recession follows.
Lenders and Borrowers
So, the repercussions from the Credit Cycle of the last 20 years include a massive increase in debt … not just by the federal government, but also by many U.S. corporations. The ratio of Debt to gross domestic product is at record levels.
When interest rates rise, the resulting fall in bond prices will leave many lenders holding the bag. Those lenders include Bond Funds and ETF investors and those of us who hold individual corporate bonds.
Who will buy when we want to sell? It is not only Borrowers who have become accustomed to easy credit. Many lenders assume they can exit at a moment’s notice. The “Great Recession” caused by the 2008 Financial Crisis showed
what can happen when borrowers can’t roll over debt easily.
High-Yield Debt
The same situation exists today, except that the debt is in areas other than home mortgages, and much of the debt today is much riskier high-yield debt. Total corporate debt, and especially high-yield debt issuance, has exploded since 2009.
Market-Making
It is important to understand how politics has had an effect on the market for corporate debt. This will explain one of the primary reasons for the recent loosening of requirements of the Dodd-Frank banking law.
The major causes of the 2008 Financial Crisis are attributable to the Federal Reserve monetary policy (the Credit Cycle) and government spending during the Bush/Cheney Administration. Reacting to the Crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Dodd-Frank also authorized creation of the federal Consumer Financial Protection Bureau.
The law and ensuing regulations discouraged banks from making markets in corporate and high-yield debt. Traditionally, firms which “make markets” are willing to buy, sell, and hold securities. They exist under rules created by stock exchanges, and are regulated by the U.S. Securities and Exchange Commission.
The tighter Dodd-Frank requirements reduced major bank market-making abilities by almost 90%. Other entities picked up the slack; bond market liquidity has been maintained in recent years because hedge funds and other non-bank lenders have filled the gap. But, these “shadow banks” are not in the business of protecting your assets. They are concerned with their own profits and those of their clients.
The problem is that these are not true market-makers. Nothing requires them to hold inventory or buy when you want to sell. In this environment, bids can “dry up” when you need them most.
We will continue discussing Debt problems next week.