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SEPTEMBER 19, 2018

 

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We used the last few issues of  IntelDigest  (just before our Summer Hiatus)
to hammer home the point that  Debt  is a major problem in the world, especially for us here in the U.S.   The “way of life” which has been built in this country over the last century will be threatened by the  National Debt, as well as runaway corporate and individual  Debt.

Over the last 20 years, businesses, governments, and individuals have amassed unprecedented amounts of  Debt, much of which must be repaid in the near future.  It is difficult to see where they will find the resources to do so.

To illustrate that this dilemma is not peculiar to Americans, we reproduce a piece reported this week in the U.K. on Sky News.  The headline is, “Next financial crisis ‘has begun and will be worse than 2008 crash,’ economists warn. Economists who predicted the 2008 global meltdown tell Sky News the world economy is in danger once again.”  It is produced by business correspondent, Adam Parsons.

 

 

The beginnings of another financial crisis are already in motion – and it will be worse than the global meltdown of 2008.

That’s the opinion of one of the select band of economists who predicted the 2008 economic collapse, which started with the bankruptcy of Lehman Brothers bank a decade ago and ended up affecting every country in the world.

Ann Pettifor predicted that crisis in 2006, more than two years before it actually struck. Now she thinks the global economy is in danger once more thanks to huge corporate debt, and the prospect of rising interest rates in the United States.

She told Sky News that global debt was now more than three times the level of global GDP.

“So naturally it is not going to be repaid, and naturally there is going to come a point when that debt triggers the next crisis. And, for me, that trigger is going to be high rates of interest,” she said.

“We’re seeing that companies who borrowed too much money at very low rates of interest are now finding the value of their collateral falling. Their debt is rising and the interest on that debt is rising too.”

What’s more, she thinks the process has already started.

She said the US Federal Reserve’s decision to wind back its support for the economy, and reverse its programme of quantitative easing, has already laid the ground for the next crisis.

“In Argentina and Turkey, they are already facing a crisis as a result of the Fed’s decision to diffuse the bomb that is QE, and to increase interest rates,” she said.

“Those decisions have both served to strengthen the dollar, which has hurt their economies.”

She said: “I think it will be worse than the last crisis because we don’t have the tools. It will be really difficult to start pumping out quantitative easing, buying back all those assets.

“Already the new crisis has begun to roll.”

She believes the UK is “vulnerable” to another crisis because of the economic volatility caused by Brexit.

And she also fears the vulnerability of the so-called “shadow banking” sector – financial institutions, such as hedge funds, that are not nearly as regulated as our best-known banks.

Her warning is echoed by others.

In an exclusive interview, Tom Russo, former managing director of Lehman Brothers, told Sky News “the seeds of the next crisis are probably already being watered right now”.

He puts the focus on the process of leverage – a measure of corporate debt.

“I think it’s probably going to be the same fundamental issue of leverage that we had 10 years ago,” he said.

“We have a national GDP of $20tn, but debt of $21tn. Our national debt is growing by $1tn per year. We keep on promising things to people without the means to pay for it. It will just become harder and harder to deal with it.”

Stuart Plesser, a senior director at the rating agency Standard & Poor’s, is one of the most respected banking analysts in America.

He said: “There are single B [a low credit rating] companies who are borrowing a lot of money, because rates are low.

“They have borrowed pretty significantly and so, if they don’t have a really viable business or business is impacted by something in the economy, or if rates go up, then the concern is this – can these companies, that have borrowed so much, really have the werewithal (sic) to pay back the debt they took on?”

 

 

 

In the May and June issues of  IntelDigest, we started  Looking Ahead  to the problems waiting over the horizon for the U.S. Economy.  After the currently-frothy markets play out … probably by the end of this year … complications await, in 2019 and thereafter.

Feel free to review those issues … and our in-depth treatment of the  Debt  crisis (from late-June through early-August).

You can find all past issues in the  IntelDigest  archive.

Next week, we will discuss Self-Directed IRAs.  When the markets hit the skids next year, we will likely enter a period of several years where stock/bond market gains will be hard to come by.  We will need alternative investment vehicles in order to earn reasonable levels of income and capital gains.  Self-Directed IRAs can provide a better platform than the typical brokerage account for finding such investments.

 

 

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IntelDigest

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SEPTEMBER 12, 2018

 

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Our Summer Hiatus is over, and  IntelDigest  returns with new content.  Today, we would like to ask for your opinion on our content.

We will list, below, some topics which we will explore over the coming months.  However, we would like to receive input from our readers.  Alert us to topics of interest to you!

As stated in the masthead,  IntelDigest  focuses on themes pertinent to Law, Policy, Finance, and the Markets.  In past letters, we have delved into analyses of legislation, such as the landmark tax overhaul;  discussed economic and trade policies; explained the structure and workings of The Federal Reserve; examined trends in employment;  decoded the BlockChain and cryptocurrencies;  interpreted trends in the Economy and investment markets.

Going forward, we intend to discuss:

* China, from several angles, over a series of issues

* U.S. Taxes – updates on changes in the law and regulations

* Work in America – a re-examination

* Robotics and Autonomous Vehicles

* Blockchain – new developments

* Medicare and Medicaid rules

* Self-Directed IRA plans

Feel free to call or email us  …  let us know what you would like to read about in  IntelDigest.

 

 

InnOvation Capital & Management, LLC

IntelDigest

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AUGUST 1, 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.

 

For several weeks, we have been reporting the depressing facts on the state of  Debt  around the world, particularly in the American Economy.  Sorry, but this information is too important to ignore.

This will be the last issue in the  current  series on this subject. However, you can be sure that Debt will come up again and again in future issues of  IntelDigest.

We intend to go on to other topics of interest in the coming months:

* China, from several angles, over a series of issues

* U.S. Taxes – updates on changes in the law and regulations

* Work in America – a re-examination

* Robotics and Autonomous Vehicles

* Blockchain – new developments

 

Need for Action

We have laid out incontrovertible evidence that the “powers that be” … whether executive or legislative … must take seriously our National Debt and take action to reduce it. However, the U.S. Congress has shown no willingness to do so over the last 20 years, nor have either Republican or Democratic Presidents since the Federal Deficit began to soar out of control after the 9/11 Attacks.

The subject is too uncomfortable, so they don’t discuss it all!

 

To close this current series, we’ll just summarize the principal problems in a few bullet points:

* Total government  Debt  in the U.S. … including federal, state, and city  Debt, and “unfunded liabilities” … exceeds $200 Trillion, by some estimates

* We know of no system of mathematics by which these liabilities can be paid off in a normal manner, so some form of “Mass Remediation Event” is likely in our future .. probably within 5-6 years … which will be a staggeringly unsettling event for creditors and investors

* The Congressional Budget Office (CBO) projects that federal entitlement payments will absorb ALL U.S. federal revenues, every year, beginning in approximately 18 years … this assumes that Congress does nothing to modify the Social Security and Medicare systems, in terms of eligibility, benefits, or funding

* Corporations have benefited from the Ultra-Low Interest Rate environment which has been in place for almost ten years, since the 2008 Financial Crisis … some companies have used their borrowing power to rebuild their balance sheets, improve operations, fund innovation, or make new products … however, far too many corporate leaders have put their companies into debt to fund share buybacks, leaving these companies more leveraged as we move into a Higher Interest Rate environment

* Corporate Debt now exceeds 72% of Gross Domestic Product (GDP) … Government Debt exceeds 100% of GDP … Household Debt is at 77% of GDP … Financial Company Debt is at 81% of GDP

* Much of the Corporate Debt is now in the form of bank loans (rather than selling bonds into the marketplace), and most loans are on short maturities of two or three years … so, many companies will have to roll over their  Debt  at higher interest rates in 2019-2021

* 37% of current U.S. Corporate Debt (of non-financial companies) is below investment grade … that equals approximately $2.4 Trillion

* non-financial companies are now approximately 20% more leveraged than they were at the time of the 2008 Financial Crisis … either having learned nothing from that experience, or willing to have faith that the U.S. government or The Federal Reserve will bail them out of future difficulties

 

Feel free to look back on this series on  Debt  in the  IntelDigest archive.  We have been looking ahead to the long-term prospects for the Economy starting with the May 16 issue (which was actually a re-publication of February 21).  And, we have devoted much of June and July to various aspects of the  Debt  problem.

 

A prudent use of debt can be a good thing, allowing us to bring the future into the present.  Most of us have done that several times during our lives, usually to purchase a home which we cannot buy outright.  For most people, an affordable home mortgage is the best use of debt.

A person can reasonably go into debt to pay for education which will raise one’s income and standard of living in the future, or that of his/her children.  A company can go into debt to buy a factory or equipment which will help to bring in revenue over the years.

However, the last 20 years has seen businesses, governments, and individuals build up massive amounts of  Debt, much of which must be repaid in the near future.  It is difficult to see where they will find the resources to do so.

That is why we have referred alternately to a  Great Reset  or  Mass Remediation Event  or  Debt Jubilee  in a few years … something which would be incredibly disruptive, but may well be necessary.

More, in future issues of  IntelDigest.

 

 

 

InnOvation Capital & Management, LLC

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JULY 25, 2018

 

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Well, if you’re not thoroughly depressed by the discussion of “unfunded liabilities” last week, we will continue our series on  Debt  in this issue of  IntelDigest.

We have laid out the facts on the subjects of corporate  Debt and government  Debt.   We’ll talk about personal Debt today … Student Loan Debt, Consumer Debt, and Auto Loan Debt.  We begin with student loans, which will probably constitute the next “subprime” crisis.

 

Student Loans

Student Debt  is at record levels, amounting to more than $1.5 Trillion!  That is the second-largest source of household debt after home mortgages.  Much of the  Student Debt  has accumulated in recent years … total indebtedness doubled from 2009 to 2016.

The average college student graduates with more than $30,000 in  Debt, and typically racks up another $6,000 in credit-card  Debt in just a few years after graduation.  Compare that to median earnings for Americans aged 25-34 … $36,000-$40,000.

That means that many recent college graduates begin their adult lives with a personal debt-to-income ratio close to 100%!

The level of  Debt  assumed by our youth threatens to become another catastrophic bubble in the American economy.  This burden causes borrowers to forgo spending and other forms of borrowing, which restrains our economy.

One in every four borrowers is delinquent or in default;  42% of federally-owned student loans are not being repaid as expected or on-time.

According to the Wall Street Journal, 33% of student loans are held by subprime borrowers.  It is projected that as many as one-third of college graduates will likely default on their loans.

 

Consumer Debt

The Debt Crisis goes far beyond student loans and home mortgages.  American consumers now owe more than $1 Trillion on their credit cards, which carry interest rates as high as 15%, 20%, even 28%!

The Center for Microeconomic Data (CMD) Quarterly Report on Household Debt and Credit recently reported that:

“… total household debt reached a new peak in the first quarter of 2018, rising $63 billion to reach $13.21 trillion. Balances climbed 0.6 percent on mortgages, 0.7 percent on auto loans, and 2.1 percent on student loans this past quarter, while they declined by 2.3 percent on credit cards.

“Aggregate household debt balances increased in the first quarter of 2018, for the fifteenth consecutive quarter, and are now $526 billion higher than the previous (2008:Q3) peak of $12.68 trillion. As of March 31, 2018, total household indebtedness was $13.21 trillion, a $63 billion (0.5 percent) increase from the fourth quarter of 2017. Overall household debt is now 18.5 percent above the 2013:Q2 trough.

“Mortgage balances, the largest component of household debt, increased somewhat during the first quarter. Mortgage balances shown on consumer credit reports on March 31 stood at $8.94 trillion, an increase of $57 billion from the fourth quarter of 2017.”

 

Auto Loans

Most people have no idea how pervasive subprime loans have become in auto lending.

In the Good Olde Days, auto lending was a simple and safe business, just like home mortgage lending.  Local and regional banks (or finance companies) would provide loans to customers having good credit and a substantial down payment. The term of the loan wouldn’t exceed the useful life of the car.

Under these conditions, auto loans were extremely low-risk. Historically, losses on auto loans were extremely low … less than 2%.  Even during the Great Depression, auto loans performed well.

The Auto Lending train went off the rails around 2011, when Wall Street firms started buying up auto-lending groups.  They changed the terms:  extending auto loans up to 84 months, lowering down payments (on leases, they’re next to nothing), and radically lowering the credit scores required to qualify.

Now, more people than ever before are borrowing money to buy cars.  Americans now owe more than $1 Trillion on auto loans.  More than 40% of the adult population has an auto loan, some at interest rates are as high as 20%.  Nonprime, subprime, and deep-subprime borrowers owe 37% of this Debt.

And, increasing amounts of subprime auto loans are being securitized and sold to other investors, just as happened with home mortgage lending in the years leading to the 2008 Financial Crisis.   Securitization  moves credit risk away from the car companies and finance companies, directly into the laps of investors.

As we all experienced during the 2008 housing bust, subprime lending becomes a major problem for the economy when it comprises too great a share of total lending.  Overall credit quality can collapse.  That scenario is playing out now in the auto loan business.

 

Summary

The United States has become the largest debtor in human history … such a  Debt Burden  is a poor legacy to leave for our children and grandchildren.

Too many Americans now die in debt, leaving burdens on the next generation and raising the likelihood of another Great Recession, or full-blown Depression.

Massive amounts of  Debt  now rest on the shoulders of the poor.  The debt load for the poorest 20% of Americans is up nearly 300% in the past 20 years.

Debt  of this magnitude cannot be financed normally.  Debt  that can’t be paid won’t be paid.  An entire generation of young Americans will suffer … many will have no hope of affording the “American Dream.”

 

Innovative solutions will be vital to our economy.  A number of writers are seriously contemplating a national “Debt Jubilee” … a mass forgiveness of  Debt, which would be a body-blow to lenders and other investors.

If things get that bad, we’ll tell you all about it in  IntelDigest.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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JULY 18, 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 the “Summer of Debt” … actually, it’s just our series on  Debt, and the many problems coming to our economy as a result of  Debt … in this issue of  IntelDigest.

This week, we will address specific aspects of U.S. government obligations. Next week, we will discuss individual  Debt, including mortgages, credit cards, student loans, et al.

As we wrote last week, government borrowing has reached historic levels. Today, the U.S. government owes more than 21 Trillion Dollars.  As of today, the number is approximately $21.2 Trillion, equal to about 105% of Gross Domestic Product (GDP).

Add in state and local debt, which amounts to another $3.1 Trillion … the total government  Debt  in the U.S. currently stands at $24.3 Trillion, more than 120% of GDP.

However, those Trillions of Dollars represent only the “official, on-the-books” Debt.

 

Unfunded Liabilities

The “official” federal  Debt  does NOT include “Unfunded Liabilities” … promises made to many people WITHOUT putting aside money to pay for those promises.  In fact, Uncle Sam has made many many promises to many many people, with little regard for its future ability to fulfill them.

These, too, represent  Debt  of the federal government, piled atop obligations already appearing on the national balance sheet.  Worse, generations of American citizens have planned their retirements based on the government fulfilling those promises.

What happens to millions of our citizens If those promises are not met?

 

Social Security and Medicare

You may be thinking, “wait a minute … Social Security and Medicare have been funded through payroll contributions by both employers and their employees.  What about the trust funds full of those contributions?”

Those “trust funds” are really just an “accounting fiction.”  Social Security and Medicare tax payments are deposited in the general fund of the United States, and the government leaves an IOU in the “trust.”

Think of it this way:  You have saved $100,000 for your child’s college education.  BUT, you have borrowed all that money to pay for your car or mortgage or vacations.  You can pretend that the money is still there to pay for future college costs, but what do you do when the first tuition bill comes in?  You will have to make college payments out of your then-current income stream, or liquidate other assets.

That, in a nutshell, is the government plan for paying future Social Security and Medicare benefits.

It is true that the dedicated revenue streams from payroll taxes, and premiums paid in by Medicare recipients, have covered current expenditures to date, and built up some reserves,  However, those income streams are about to go negative.  Going forward, current income will not be enough to pay all current benefits.

With both programs going into negative cash flow, the U.S. Congress must now take action to provide additional cash to pay the promised benefits.  The annual trustee report has estimated that Social Security will run out of reserves in 2034, and the hospitalization part of Medicare will go dry in 2026.

 

The Semantics of Assumptions

Having already “borrowed” all the money in the Social Security and Medicare trust funds, the federal government is being disingenuous in projections of “running out of reserves” in 2034 or 2026.  The government has already used all “reserves,” and will have to pay future benefits out of then-current income.

But, as an academic exercise, let’s play the “assumptions game.”  How did the government determine that the Social Security “reserves” will last until 2034, and Medicare reserves until 2026?  These estimates are based on lots of assumptions.

To estimate revenue, government economists must know how many workers are in the United States, their wages, and at what rates those wages will be taxed.  To estimate expenses, they must know how many retirees will be drawing benefits, the amount of those benefits, and how long the retirees will live to receive them.  They also have to assume an inflation rate on which the cost-of-living adjustment is based.  A small deviation in any of those can have huge long-term consequences.

The government estimates that Social Security has a $13.2 Trillion unfunded liability over the next 75 years.  That is the amount of benefits which the government expects to pay, minus the revenue expected to come in.

Medicare projections require even more assumptions:  what kind of treatments the program will cover, how much treatment senior citizens will need, and what those treatments will cost.  All these could vary wildly, but the “official” assumptions put the Medicare 75-year unfunded liability at $37 Trillion.  It could be vastly more.  Or, if medical science finds ways to keep us healthier in the future, then healthcare costs could be less, as could the total unfunded liability.

But, the current assumptions indicate total unfunded liabilities of approximately 50 Trillion Dollars!

Of course, this scenario depends on government assumptions being spot on (unlikely), and the United States averting wars and other political conflicts which could blow these assumptions out of the water!

Economist Laurence Kotlikoff and financial columnist Scott Burns addressed these issues in their book, The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy.  They take a rather dim view of our elected representatives, writing that the “… only truly bipartisan cooperation in Congress is that both sides lie.”  And, that any time a politician talks about putting a “lock box” around Social Security or Medicare trust funds, he or she is either staggeringly ignorant or lying.

By the way, Professor Kotlikoff estimates the unfunded liabilities to be closer to $210 Trillion!

 

Summary

So, at a minimum, we can probably assume that Social Security and Medicare add another $50 Trillion of Debt on top of the $21.2 Trillion (and growing) on-budget federal  Debt.

By the way, none of the foregoing discussion includes civil service or military retirement obligations, or the federal government backing for some private pensions under the Pension Benefit Guaranty Corporation, or open-ended guarantees like FDIC, Fannie Mae, et al.

What solution will Congress provide for angry retirees who think they have already “paid” for their benefits?  Can they make strategic modifications (benefit cuts) to these so-called “entitlement” programs to extend their efficacy?

In reality, arguing over whether it’s a $50 Trillion or $200 Trillion problem is pointless.  Congress will have to act … rather sooner than later … to cut spending or raise taxes, or some combination of both.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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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.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

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JUNE 27, 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 discussion of the problems for the U.S. Economy in the near future.  For this week and next (and probably the following week), the subject will be  Debt … its many forms, and its impact on our economic well-being.

Our responsibility … to our clients, colleagues, and friends … is to reveal the myriad ways that  Debt  creates complications for our economy.

As we noted last week, 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.

 

Covenant Quality

Last week, we touched on the subject of  Covenants  in the context of Bonds.  Remember that investment Bonds are Debt instruments.  Covenants  are the basic rules which govern the agreement between borrower and lender with respect to various Debt instruments, such as Bonds and Loans.   Covenants  enforce the requirements of the issuer … what the company can do (positive covenants), and what it cannot do (negative covenants).

A common example, with respect to a Corporate Bond, is the “restricted payments covenant.”  This provision protects the lender (investor) by limiting the company’s ability to make distributions and asset transfers which would hinder the borrower’s ability to repay the debt.  This can include restrictions on stock repurchases, prepaying junior debt, and dividends.  Other covenants may require certain debt-to-assets or interest coverage ratios.

Over the past few years,  Covenant Quality  has declined dramatically with respect to leveraged loans.  Leveraged loans are loans issued by companies with below-investment-grade ratings.  Traditionally, these loans have featured a number of Covenants  intended to protect the lender/investor.  On the other hand, a “covenant-lite” loan has fewer restrictions, therefore more risk.

U.S. corporations and investors obviously have very short memories.  Just 10 years after the most severe financial crisis since the Great Depression, Americans are taking on record amounts of risk, in the form of “covenant-lite” leveraged loans. Featuring fewer covenants … and weaker covenants … this form of Debt allows the borrowing company to favor its own agenda and shareholders, to the detriment of holders of its Bonds.

Today, according to S&P Global Market Watch, 77% of leveraged corporate bonds are “covenant-lite,” meaning that the borrower (issuer of the bond) doesn’t have to repay by conventional means.  Sometimes, they can even force the lenders to take more debt.

U.S. “covenant-lite” loan issues for 2017 were the highest in over a decade, a record $677 Billion.  This was almost double the $350 Billion in the previous year.  By comparison, the amount in 2007 was $150 Billion.

So far in 2018, American corporations are on pace to issue over $600 Billion in new “covenant-lite” Debt.

When the  Credit Cycle  turns over, Declining Covenant Quality will make things very difficult in the Bond space.  With interest rates continuing to rise, corporate borrowers will find it more and more difficult to pay off their Debt.

Because of the massive amount of Debt which has been amassed over a prolonged period of ultra-low interest rates, Corporate Bond Defaults will be the inevitable result.

 

A Looming Corporate Debt Crisis

As rates rise, government bonds will become a viable alternative to other assets again.  If an investor can earn an adequate return in a risk-free Treasury, riskier stocks and corporate bonds will become relatively less attractive. H igher interest rates create a stronger and stronger headwind for other assets.

The ultra-low interest rate regime of the last decade … created by the Federal Reserve and other central bankers … allowed thousands of companies to borrow money, including many which would have gone bankrupt without the infusion of “cheap loans.”  There are now several hundred publicly-traded corporations which will NOT be able to repay their debts in the coming crisis.

Several hundred American companies are destined for bankruptcy in the near future.

 

Consequences of the Debt Crisis

Here is a brief outline of the likely order of events in the Great Unraveling of the next few years:

Illiquidity will spread as lower-end corporate bonds fall to junk ratings.  Then, legal and contractual constraints will force institutions to sell, pressuring all but the highest-grade corporate and sovereign bonds.

Go back to our discussion of the  Credit Cycle  in the June 13 issue of  IntelDigest.  Instead of recession pushing asset prices lower, lower asset prices trigger the recession.  That will be the next stage as falling stock and bond prices hit borrowers.

Rising defaults will force banks to reduce their lending exposure, drying up capital for previously creditworthy businesses.  This will put pressure on earnings and reduce economic activity.   Recession  will follow … here, and around the world.

As always, a U.S. recession will spark higher federal spending and reduce tax revenue.  The federal government deficit will quickly rise to $2 Trillion per year.  Total federal  Debt  will reach $30 Trillion within four years.

Private capital markets will be constrained, and everyone will “enjoy” rising tax burdens.

American jobs will be endangered because of the massive amount of corporate  Debt.  As the weaker companies approach default, they will be desperate to cut costs.  Cutting human workers and moving to more automation … this will be a likely strategy.  Both manufacturing and service jobs are in jeopardy.

We will publish a new series on the prospects for the American Worker later this year.

More details on the coming  Debt Crisis  next week.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 20, 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 been  Looking Ahead  to the problems waiting over the horizon for the U.S. Economy.  After the currently-frothy markets play out … probably by the end of this year … complications await, in 2019 and thereafter.

We have warned of the prospects for  Stagflation, perhaps as soon as 2020;  and, discussed the evolution of  Credit Cycles  in the transformation of world economies.  This week and next, the subject will be  Debt … its many forms, and its impact on our economic well-being.

 

Credit Cycles

Our discourse on  Credit Cycles  revealed a fundamental change in economic cycles, attributable to central bankers, particularly the U.S. Federal Reserve (The Fed).  Over the last 20 years, American companies and individuals have learned from The Fed that running up  Debt  is easy and fun!

Unfortunately, Debt  eventually becomes a drag on growth. Debt-induced growth pulls spending forward, reducing a future recovery.  Debt  also artificially boosts asset prices.

The repercussions from the  Credit Cycle  of the last 20 years include a massive increase in  Debt … by the federal government, by many U.S. corporations, and by millions of individual Americans.  The ratio of  Debt  to gross domestic product is at record levels.

This environment sets up the American economy for financial instability.

 

Financial Instability Hypothesis

Professor Hyman Minsky of Bard College published his Working Paper on the  Financial Instability Hypothesis  in 1992. His basic point:  that over-exuberant companies become paralyzed when they take on too much  Debt, and this leads to a financial breakdown.

The hypothesis was clearly illustrated in 2008, when overexposure to subprime mortgages and their associated derivatives led to a breakdown in the banking systems, which almost brought down the U.S. economy.

Today, there is a much greater risk of financial crisis on the horizon because of the sheer amount of corporate debt now outstanding, especially high-yield bonds which will be difficult liquidate in a crisis.

 

Illusion of Liquidity

Economist Louis Gave recently published an article titled, “The Illusion of Liquidity and Its Consequences.”  In his research, he looked at corporate bond ETFs and compared the total Dollar amounts to the inventories of trading desks … this is a rough measure of liquidity.

Gave found that dealer inventories are not remotely sufficient to accommodate the bond-selling expected as interest rates rise.  The bond market has doubled in size in recent years, while the willingness and ability of bond dealers to provide liquidity under market stress has fallen by more than -80% in the same period.

Here is a likely scenario:  as interest rates rise, the value of bonds in mutual funds and ETFs falls.  The investors … often regular Americans and retirees seeking yield … all try to sell at once.  The funds must meet these redemptions, so they will sell at whatever prices are available.  In a bear market, you sell what you can.

Speaking of the investors, much of the Two Trillion Dollars currently invested in bond mutual funds and ETFs are NOT owned by “traditional” long-term investors in bonds, who would often hold the bonds until maturity.  Therefore, when bonds start to fall, there will be thousands of demands for redemption.

The funds may find that there will be no bids for the lesser bonds in their portfolios, so they will have to sell the best bonds in order to meet redemptions.  Remaining investors will be stuck with increasingly poor-quality portfolios, which will lose value even faster

The word “calamity” may not be too strong in describing the markets then.

Making matters worse, many lenders 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.

According to S&P Global Market Watch, 77% of leveraged corporate bonds are “covenant-lite,” meaning that the borrower (issuer of the bond) doesn’t have to repay by conventional means.  Sometimes, they can even force the lenders to take more debt.

Buying such bonds may have been a good idea at the time … what happens when the times get tough?

 

Rolling Over the Debt

According to Wells Fargo Securities,  Four Trillion Dollars  of corporate 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

As interest rates rise, that  Debt  becomes more expensive to extend.  Many companies will lose the ability to service their debt.

Investors would be justifiably concerned.  Combine unprecedented amounts of borrowing with interest rates rising steadily, and corporate balance sheets approach a
tipping point.

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  ensues.

More on  Debt  next week.

 

 

 

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.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 6, 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.

 

In the June issues of  IntelDigest, we will continue our  Look Ahead  at the Economy-To-Come … planning for the transition from the 9-year Bull Market to leaner times ahead.  We will discuss  Credit Cycles, as well as the role of  Debt  in the Unraveling to come.

We will also examine the following topics over the course of the Summer:

* China, from several angles, over a series of issues

* U.S. Taxes – updates on changes in the law and regulations

* Work in America – a re-examination

* Robotics and Autonomous Vehicles

* Blockchain – new developments

Today, we’ll talk about Investing Fundamentals – important considerations when investing in a Bear Market.

 

The Unraveling

We pointed out, in our May 23 issue, that The Federal Reserve has been tightening the money supply since late last year.  The Fed’s unwinding of its massive bond portfolio has continued at a rate of $10 Billion per month in U.S. Treasury securities and $3 Billion per month in mortgage securities.

Equities markets rolled higher and higher over the last nine years on a tide of ultra-low interest rates and “Quantitative Easing” concocted by central bankers, including The Federal Reserve in the U.S.  The Fed has reversed course with the new regimen of tightening, draining liquidity from the system, along with the prospect of gradual raising of short-term interest rates.  With access to cheap credit drying up, the financial “tide” is now rolling out.

 

Investing in a Bear Market

We are transitioning from a historic Bull Market … when it was relatively easy to earn profits on stocks across-the-board … to a slowly unfolding Recession and Market Downturn.  Many will want to sell all their stocks and hide under the bed by next year.  Prudent investors, on the other hand, will want to hold onto the best, income-producing stocks in their portfolios.

However, investing in stocks during a Bear Market requires selectivity and discipline.  So, here are some important guidelines to anchor your portfolios in the coming lean years.

* Protecting Capital

When Selectivity is an important element of your investing approach, you should seek conservative stocks.  The time for speculation is past;  minimizing threats to your capital is paramount.

You want to own shares of companies which offer true value, and will pay you regularly for your ownership.  That means dividend-paying stocks.  As your payments add up, you can worry less about the price movements of the stock, especially when the markets in general are sagging.

This is a time to be patient with the markets, and avoid overpaying for any stock.  Don’t chase stocks higher;  set your price target, and wait for the stock price to come back to your target.

If you pay the right price for a company, there’s a good chance that the stock will trade higher when other investors realize the value of the company.

 

* Investing for Growth

Selectivity and discipline require research.  You (or your advisor) must explore the history of your target companies … have they grown profits, dividends, free cash flow on a consistent basis?  If a company’s cash flow and profits are not keeping up, it may have to cut the dividend.

Stock Prices during a Bear Market can be stuck in the mud for years, so you want companies which can make stable payments to you over several years, and continue growing those payments over time.

 

* Seeking Yield

We still live in a low-interest-rate world, so finding opportunities to earn a decent yield can be a struggle.  Bank deposits will continue to be low-yield for a few more years, and the corporate bond market is risky, especially as we head into a Credit Crisis in 2019-2020.

The best bets for a safe yield in the coming years will be (1) income-producing real estate, and (2) stable dividend-yielding stocks.  This is the safe middle ground.

Also, high-yield dividend-paying stocks will attract the attention of other investors, which would support the share price.  We want to be ready to move into high-quality stocks early in the Recession, after the initial breakdown of the stock market;  or, if we already hold them, be prepared to hold fast during the initial crash

By taking an early position in (or, holding on to) solid dividend stocks, we have a good chance of earning an attractive yield, from both a rebound in the stock price and regular payments from dividends.

 

* Understanding the Business

Just as you want to avoid speculating during a Bear Market, you should also avoid uncertainty.  You should not invest in a company if you don’t fully understand how it makes money.

Again, proper research is necessary.  It is well worth your time to learn about the products or services which a company offers, who are its customers and competition, how it earns its profits, and which units of a company are profitable or may be behind the competition.

If you understand a business well enough that you can clearly and succinctly describe the business to your friends or family, then you will be better equipped to make an investment decision.

 

* Finding Quality

After the research referred to above, you can make the threshold decision:  are you comfortable committing a portion of your net worth to a certain stock?  Are you convinced that the investment represents an exceptional opportunity?  You shouldn’t invest your hard-earned money in anything less.

You want to be sure that you’re buying a high-quality business, and its financial “attributes” make it a good investment.  That could mean that the company is highly capital-efficient;  has pricing power or dominance in its industry;  or, features a stock value which is low relative to its asset value.

If you have confidence that a company offers an excellent potential return on investment, then you will have the courage of your convictions when the markets are in a sluggish or declining mode.

 

* Settling In for the Long Haul

Warren Buffett famously wrote, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.  (Berkshire Hathaway 1996 letter to shareholders)

Investing in a Bear Market requires a long time horizon.  In that same letter, Buffett advised investors to “… Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

In a Bear Market, you should be ready and willing to commit to holding your stocks for 10 years.  Over the long run, stock prices are highly correlated with earnings growth.  Focus on durable, growing franchises.  You will want to hold businesses which you feel confident will be bigger and better in the years to come.

 

Following the Guidelines

The purpose of these Guidelines is to get you to concentrate on only the most stable opportunities during the lean times of a Bear Market … to eliminate marginal ideas from your portfolio. This is the mind set of private-equity professionals.

Thinking like a whole-business owner will help ensure that you own strong, enduring businesses … businesses which you know well and are comfortable holding through the storm.

Plan now to have your financial house in order so that you’re playing a strong hand during the lean times.  Pay off debts.  Build positions in Cash and Gold.  Follow the trailing stops in your portfolios over the remainder of this year.

When the storm hits, you will be in the best position to weather it.  This will allow you to sleep at night, focus on the big picture, and make better investment decisions in the years to come.