InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
JULY 11, 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 continue our series on Debt, and the many problems coming to our economy as a result of Debt, in this issue of IntelDigest.
As we have written in recent weeks, Debt has been much too easy to amass over the last 20 years. It has artificially boosted asset prices, and will become a serious drag on growth in the near future.
Making matters worse, many lenders (investors) are now more highly leveraged than they were ten years ago. Many have bought their corporate bonds with borrowed money, confident that low interest rates and low defaults would keep risks manageable.
Rolling Over the Debt
According to Wells Fargo Securities, Four Trillion Dollars of bonds in the U.S. must be refinanced over the next five years. This amounts to over 65% of all outstanding corporate debt in this country.
Investors would be justifiably concerned … combine unprecedented amounts of borrowing with interest rates rising steadily, and corporate balance sheets approach a tipping point.
As our economy enters recession, many companies will lose their ability to service their debt. Several Trillions of Dollars of corporate Debt are scheduled to “roll over” in the next few years. As interest rates rise, that Debt becomes more expensive to extend.
When companies can no longer service their Debt, they have to cut back. They will do so by laying off workers, reducing inventory and investment, or selling assets. All of these actions reduce growth. If reductions spread across the country, we get economic contraction, and Recession.
The Scourge of Debt
Taxation is an arrangement by which government takes money from our pockets … theoretically, to provide services for our benefit. However, when government incurs Debt, it is taking from our children and grandchildren.
Government borrowing has reached historic levels. Today, the U.S. government owes more than 21 Trillion Dollars. That is approximately $180,000 for each American taxpayer.
A 2014 Harvard study provides perspective on the problem (dollar figures have been updated to 2018 levels):
If the federal government provided NO operations, and spent its annual revenues exclusively on debt reduction, it could pay down its debt in three or four years. Or, the government could pay down the debt in one blow if it simply took more than $65,000 from every person living in the U.S., including children, the elderly, and the unemployed. (As mentioned above, the figure would be approximately $180,000 per taxpayer, if children and the elderly would get a pass).
If the government had to pay even 6% interest on its debt, it would cost roughly $1.2 Trillion per year. And, that’s just to pay the interest on the debt. The entire government brings in approximately $3.3 Trillion in taxes every year.
Debt Addiction
Adding up all of our government, corporate, and consumer debt, America owes roughly $70 Trillion … that would be approximately $836,000 per American household
This is truly a “debt addiction.” Instead of learning from the mistakes that crippled our economy in the 2008 Financial Crisis, the U.S. has created more bubbles which have the potential to implode our economy.
The largest threat is the U.S. corporate bond market, particularly junk bonds.
There has never been a bigger bubble in U.S. bonds.
In recent years, the difference between the yields on junk bonds and the yields on investment-grade bonds has been very small. Credit was more available than almost ever before for small, less-than-investment-grade companies. The last time that credit was that widely available … at such low costs … was 2007.
We know where that led.
A collapse of the bond market in the next two years would be far worse than the 2008 Financial Crisis. U.S. monetary policy since 2008, as implemented by The Federal Reserve (The Fed), has featured ultra-low interest rates and The Fed spending Hundreds of Billions of Dollars to purchase Treasury securities and mortgage-backed debt. This has driven the huge Bull Market in bonds. As The Fed bought bonds, bond rates fell, forcing other buyers of bonds to buy riskier debt which (historically) offered much higher yields.
When panic hits the corporate bond market … perhaps as early as next year … the average price of non-investment-grade debt (junk bonds) could fall as much as 50%. Investment-grade bonds would also take a tumble, perhaps by 25%.
This would wipe out a huge amount of capital. Junk Bond expert Martin Fridson has projected that $1.6 Trillion of bonds and loans will default. That would be three times as many debt issuers as defaulted in the last recession.
This would have already happened, according to Fridson, but the government has kept interest rates artificially low, making it possible for many at-risk debt-issuers to refinance their debt at a lower interest rate. That delayed an inevitable wave of defaults in the junk- bond industry, but only temporarily.
Exit Strategy
Right now, it’s better to have a defensive mind set than an offensive one.
We will reiterate our opinion on the markets, which we have stated on several occasions … it is important to devise an Exit Strategy for each and every asset in your portfolio. We recommend establishing a Stop Loss level for each asset; the Stop Loss is the exit price where you will sell your position if the price drops that low. The Stop Loss can be a specific dollar price, or a percentage loss from the highest price which a stock has attained.
By setting Stop Losses and executing them without emotion, one can methodically cut losses, while allowing winners to ride.
More on the coming Debt Crisis next week.