“The rising number of so-called zombie firms, defined as firms that are unable to cover debt servicing costs from current profits over an extended period… we document a ratcheting-up in the prevalence of zombies since the late 1980s. Our analysis suggests that this increase is linked to reduced financial pressure, which in turn seems to reflect in part the effects of lower interest rates. We further find that zombies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms”.
The Rise of Zombie Firms: Causes and Consequences, BIS Quarterly Review
Given the historical relationship between the unemployment rate and bankruptcies, we would expect to see a large number of companies file for Chapter 11 in the coming months. These are likely to happen among smaller to medium sized enterprises, where access to fiscal stimulus is more challenged.
Corporate Competition and Capitalism
The COVID crisis has re-opened some festering wounds. The global wave of social unrest may have had its catalyst at a specific time and place in the U.S., but the underlying inequality had been building for years. Some may argue it was a couple of decades in the making.
For a while, the economic literature had largely ignored the loss of competition in the corporate landscape, something that had become particularly acute in the U.S. The preference of academia had been to focus on the rising income inequality and the wealthy 1%, as testified by the success of Thomas Piketty’s Capital in the 21st Century. In the last couple of years though, interest in the loss of corporate competition has come under the spotlight. Jonathan Tepper of Variant Perception published The Myth of Capitalism in early 2019 in which he simply stated that “capitalism without competition is not capitalism”. The genesis of the book was an enquiry into why wages had not picked up. Variant Perception’s U.S. Wages Leading Indicator model had accurately led the changes in average hourly earnings for twenty-five years.
In 2015, the lead indicator began to diverge from wages, which the book attributed to a rise in monopolistic and oligopolistic tendencies (i.e. corporate power becoming concentrated into fewer and fewer hands). Corporate America was becoming less competitive, and employees and customers were losing out.
In the same year, Thomas Philippon, Professor of Finance at the Stern School of Business at New York University published The Great Reversal, where he highlighted the fragility of free markets and the impact that concentration can have on consumers. For this discussion, perhaps the key insight is that “in an efficient market, the marginal firm is nearly bankrupt.” Financial distress, by itself, is not a bad sign, he concluded.
Why is all this important? Well, capitalism has been the best wealth creation system we’ve ever built, and corporate competitiveness is at its core. What happens when the system we operate in reduces competition? (Hint, its not good)
Known initially as the Greenspan Put, after the U.S. Federal Reserve Chairman Alan Greenspan who championed the policy, it aimed to ease financial conditions to support risk assets through difficult periods. The moniker would be attached to all subsequent chairman (and chairwoman): the Bernanke Put, the Yellen Put and now the Powell Put.
The legacy of Greenspan has led to a school of thought in which economic trouble and weakness in asset prices is rapidly met with a brisk monetary response. Initially, this took the form of rate cuts. Its success was perhaps more perceived than real. The U.S. equity market fell 50% from 2000 to 2003 and then again from 2007 to 2009, despite the persistent and deep cuts to interest rates.
After the 2008 Great Financial Crisis and with interest rates starting from a low base, the U.S. Federal Reserve added quantitative easing (QE) to the monetary toolbox. The Bank of Japan had already been implementing this policy, but with little effect. Even nowadays, the Japanese equity market remains more than 40% below the highs that formed when its equity bubble peaked in 1989.
In the Quantitative Easing world, we have learned that the messaging can be as important as the actual stimulus, and the behavior of German Bunds (bonds) are the best expression of that.
When Mario Draghi (then president of the European Central Bank) said that the ECB would do ‘whatever it takes’ in a speech in on July 26th, 2012, for many this marked the beginning of the end of the eurozone debt crisis. But it was a confidence trick. The ECB initially did very little that was material. The speech, however, represented a commitment to support the indebted nations of the eurozone and confidence returned to the capital markets. Rather than wait for central banks to commit their capital, investors with dry powder generally front run the efforts of policy makers. Thus, the messaging may be more important than the mechanics.
In Europe, QE programs also focused on sovereign and corporate debt. Perhaps surprisingly, bond yields fell before the bond buying programs commenced. Once the bond buying programs were in full swing, bond yields generally stabilized or even rose.
What looks like a strange dynamic can be explained by the messaging of the market. German 10-year bunds are a safe haven. When there is economic stress, bund yields fall because capital is seeking the safety of the German government bund market. Declining bund yields act as a catalyst for policy makers to take action and bund yields then stabilize once the central bank commits to bund purchases. Traders have also learnt how to play these signals, buying into the bund market momentum knowing that yields will continue to fall and bunds prices rise until the ECB is forced into taking action.
In the U.S., QE entailed the purchase of government, mortgage backed and corporate bonds in the secondary market. Bond yields have been in a steadily declining trend channel for four decades. Initially, off a very high base (they peaked the year before buybacks rules were rolled back), the steady decline in yields provided a tailwind for equities, with 1982 marking a single digit low (The Rise of S&P Price /Earnings chart below) in equity valuation which has remained in place until this day.
How does QE translate into higher prices across a wide range of assets? John Hussman of Hussman Funds has described the ‘hot potato’ effect of QE. The Fed buys government bonds in the secondary market off, for instance, a large commercial bank. The commercial bank will reinvest the cash in other securities with a higher return, which carry higher risk, buying them off, for example, a hedge fund. In turn, the hedge fund re-invests the cash in even riskier securities, pushing the ‘hot potato’ out along the risk curve.
But why is this so beneficial to the U.S. equity market? And is QE one of the reasons why the U.S. equity market has had an extended period of outperformance versus most other major markets over the last decade?
The tech heavy nature of the U.S. equity market should not be overlooked. The U.S. undeniably has some of the world leaders amongst its large cap tech names. These had been benefiting from the move toward online and cloud-based commerce even before COVID swept the world.
But the U.S. equity market has also been a constant outperformer given the size of its biggest companies, which ended up benefitting from the combination of the rise of passive investing and the stimulus from central banks. Let us explain.
Whilst Quantitative Easing means that more money flows to the equity market as bond yields continue to trend lower and market participants are forced to look for higher returns in the equity market, the rise of passive means that more of that money is allocated towards the biggest components of the stock market. We’ve explained the mechanics of this process last month:
“As new funds enter the equity market through passive strategies, typically in the form of Exchange Traded Funds, the custodians (i.e. Blackrock, Vanguard, etc.) of those ETFs use those funds to indiscriminately buy equities following the market-cap weight of a company in a certain index like the S&P 500, the Dow Jones or, of course, the NASDAQ. This means that, if I were to invest $100,000 to buy an ETF that tracks the performance of the NASDAQ, I would end up buying almost $40,000 worth of Microsoft, Apple, Amazon, Facebook and Alphabet given they constitute almost 40% of the index.”
The Lykeion, May 2020 Markets Print
Mechanically this means that QE increases the allocation of assets to the equity market, whilst passive investment certifies that, the majority of those assets flows to a specific and concentrated number of companies, which end up seeing their price skyrocket. This means that a concentrated number of companies tends to become even larger and, hence, end up capturing an ever-increasing slice of the funds. This then becomes a self-perpetuating cycle that has driven the US stock market, and its largest companies, higher for many years now. This has allowed for the market to move independently from macro and corporate level fundamentals.
So why is this more relevant in the U.S. than in other markets? Well, if the combination of QE and passive investment flows rewards size above all, and the U.S. houses the largest companies in the world, then it becomes clearer how the U.S. has seen a steeper bull run than Europe or Japan.
The policies of the U.S. Federal Reserve over the last decade have suppressed financial distress. On the face of it, that sounds like a good idea. This, however, has curtailed the forces of creative destruction. Creative destruction is a term coined by the Austrian Economist Joseph Schumpeter in 1942 as “the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
The decade before COVID had seen the opposite of this. The monetary policies adopted by the Federal Reserve prevented creative destruction to naturally take place as easy financial conditions allowed for less efficient companies to survive. With that, the total number of listed companies started declining; fewer companies went public and increased M&A activity decreased the total count of companies that were already public. Additionally, through share buybacks, companies continued to ‘retire’ shares at a record pace. Overall, we started having a much more concentrated market, which paradoxically reduces competition and, hence, the real benefits of a capitalist system.
A larger pool of wealth, created over the last few decades via the capitalist construct, is now held by fewer but larger companies with fewer shares outstanding, creating a chasm between the holders of that wealth, and everyone else. An unintended consequence of the suppression of financial distress.
Optically, everything seemed fine though as Earnings per Share (EPS) were rising. But the reality is that higher EPS were not driven by better corporate performance, but rather because the shares in circulation (denominator) were falling. In the U.S., profits had been flatlining for more than half a decade (circled below), even as the equity market soared.
The only other comparable time for shares to outperform earnings on this scale was during the period when the U.S. was gripped by the dot-com mania twenty years ago (visible in the chart as well). Equities eventually reconnected with earnings on that occasion.
When the Fed intervenes with liquidity boosts, it hopes that its generosity to its banking clients will feed through to individuals and small businesses. But the reality is that in a world of frightened cash-starved corporates, banks have a tendency to hoard cash and high-quality collateral assets (government and top-rated corporate bonds) in order to insure themselves against an uncertain future. As such, getting access to the much-needed funds is more complicated than it seems.
Larger businesses tend to have their own lawyers and accountants or have the means to employ them, which enables them to easily tackle the bureaucracy to gain easy access to funds. Small businesses, the ones that employ 70% of the U.S. workforce and the ones who are most dependent on the fiscal stimulus of government handouts, have a harder time accessing the funds given the more limited nature of their resources and the riskier profile, on average, of their business.
Furthermore, the transmission of funds into the local economy has not only been slowed down by commercial banks unwillingness to lend, but also by the decline in the number of banks. Richard Werner, professor of Banking and Finance at Oxford University recently noted that:
“If we go back only 15 years, America had 15,000 banks, but today we only have barely 5,000. Why do you need small banks? Because small banks lend to small firms. Big banks have no business lending to small firms. They’re not interested.”
There are fewer lenders catering to small and medium-sized enterprises. Stimulus is cheap to those who can afford it but very expensive to those that can’t. The cards are stacked against the new and upcoming businesses, the real engine room of growth. Once again, competition is being curtailed.
For CEOs across corporate America, the system was stacked in favor of the buybacks since the Great Financial Crisis. The C-Suite got paid off the level of the share price, not the level of profitability of the business they ran. Cash flow generated from operations or even financing activities was pumped into buybacks rather than investment (as we’ve written in our May 2020 Editorial). As cash was pumped into buybacks, growth and productivity slowed down given the reduced spending on CAPEX, which further increased the incentives for corporate America to focus on buybacks rather than PPE spend.
Growth stagnated, and with that the levels of inflation. Investors, who normally paid a yield premium for longer dated bonds given the theoretical expectation that inflation risks were higher for longer maturities, saw term premium (i.e. the yield differential between long and short maturity bonds) go into negative territory.
Whilst share prices continued to increase, the number of companies with debt servicing costs that are higher than profits (i.e. zombies) had started to rise dramatically after the 2008 Great Financial Crisis given the stagnant earnings and ballooning debt. These companies were borrowing at the artificially deflated prices that were set by aggressive central bank action and using the proceeds to buy back their shares.
Within the U.S. investment grade category of corporate bonds, BBBs ballooned to over $1 trillion, sitting just one notch above junk status and teetering on the edge of the precipice, waiting for an unexpected event to tip them over the edge. The number of zombie companies is now close to 20%. This was closer to zero twenty years ago.
The COVID pandemic came at a time of historically high leverage, fiscal permissiveness, flat earnings growth, and increasingly higher valuations and more numerous “zombie” companies.
Whilst the pandemic wasn’t an event we could have forecasted, it definitely was an event that we could have planned for. All parts of the economy – household, corporate and government – should have been prepared with a rainy-day fund. Unexpected events have roiled markets and economies throughout history, which is why we have insurance. But corporate America in particular had become used to the Federal Reserve providing the insurance for free (started with the Greenspan Put), and this time was no different. When the pandemic struck, the Fed didn’t disappoint and boosted the markets with more aggressive stimulus. This has led us into a fully formed financial markets bubble.
If the previous decade had slowly sucked the lifeblood out of future productivity by curtailing creative destruction and sponsoring an epic misallocation of capital, then the second quarter of 2020 will be on another level entirely.
On March 23rd the Fed launched a new round of QE, this time open-ended (perhaps infinite?).
This wasn’t sufficient. In April, they announced a corporate bond buying program which extended to some junk names, or fallen angels, which had once been investment grade, but because of their weak balance sheets, had quickly slipped into junk status as the first day of the pandemic reckoning began. The market again front ran the central bank money and both investment grade and junk bonds soared under a tsunami of new inflows.
Corporate America didn’t hold back. They showed a clean pair of heels to the previous peaks of corporate debt-to-GDP (this chart is updated for the end of Q1 2020 – just imagine updated for Q2!).
In the first five months of 2020, a record of over $1 trillion in new debt was issued. Zombie companies with access to capital markets were able to extend their lifespan and mummify themselves in the central bank-sponsored debt markets. High yield issuance has exploded since March.
The walking dead keeps on walking. Companies that were inefficient before the crisis are being given yet another lifeline. Despite this, the existing state of balance sheets and the scale of the slowdown has still led to a dramatic rise in corporate bond defaults. Apparently, businesses had got used to the idea that nothing bad could ever happen.
Although we had a deep correction in March, a true bubble deflates and then stays deflated for an extended period. We saw this after the dot-com bubble in 2000 and after China’s inflated equity market of 2015.
Instead, the NASDAQ in 2020 has swiftly raced back to and beyond the all-time highs.
The S&P has rebounded further than any initial bounce of any major bear market in history. These were not the actions of a post-bubble market. Compare this with how the Chinese tried to reflate its equity market in 2015 but failed (chart above).
Back in January, I argued on my weekly macro show that the equity market was not a bubble, because it lacked the euphoria of a mania (similarly to the dot-com mania or the tulip mania).
“We currently have prices that are clearly extended, but it would be very hard to say the public’s emotional involvement with asset prices is so extreme that it could lead to the sort of populist mass exit that results in extended losses in the equity space.”
January 22nd, 2020
Once emotions are damaged, they take a long time to recover. The U.S. equity market that was making all-time highs in February 2020 was devoid of the emotional buying of private investors. It was fueled by the dispassionate flows of corporates and pension funds.
Today, however, is another story. Given the rebound in financial markets and the fact that we now have the emotional involvement of the retail investors to complement the re-leveraging of the shadow banks (systematic funds and hedge funds) we can certainly say that the “mania” aspect of the bubble is fully formed. The question is, what happens next?
We know that the Federal Reserve stimulus is here to stay, but what about the other big drivers of valuations: corporate buybacks and 401k pension flows?
Looking ahead, corporate buybacks will be put on hold for companies that have borrowed funds from central banks (tech companies continue to announce significant buybacks, but they didn’t require government funds), as they’re not likely to receive public approval to be spending taxpayers money on artificially supporting stock prices. Additionally, a lower level of employment will reduce 401k flows, although the job losses have been concentrated amongst the less skilled and lower paid workforce who hadn’t generated pension flows in the first place.
With these two pillars of the equity market in retreat (buyback and 401k flows that eventually become passive flows), will we finally allow for creative destruction to take place? Or will we continue to misallocate capital, and once again curtail the potential productivity and, with it, future economic growth?
The higher the equity market rallies today, the lower will be the future growth of the economy. This is not new. It has been the experience of the last ten years, but slightly more subtly so. Hertz is just one brash example of the misallocations that are taking place in order to rescue markets from the coronavirus (more on the Hertz story in this month’s Markets print). But it’s the economy that matters as that is where society exists.
There is hope that the fiscal stimulus will create inflation. But, if the fiscal stimulus is first squandered on the equity market instead of reaching the real consumers, then the velocity of money can be expected to fall further.
The mechanism through which the money printed by the Federal Reserve reaches the economy needs to become more effective. Small and medium banks need to be able to receive the necessary capital to lend to small and medium enterprises, the core engine of the economy. Right now, we have put in place financial market stimulus rather than real economic stimulus. The Fed is creating an equity bubble, within a recession. Rising equity prices, like rising house prices, are non-productive unless individuals can lock in the returns. A few always do, but the majority usually experience capital destruction. It’s a lot easier getting into assets than getting out again.
When the equity market was at record highs in February, it lacked the mania. It wasn’t a bubble. The equity market at record highs today has the mania. It can now be labelled a bubble. Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co, who predicted the equity declines in 2000 and 2008, said in a recent interview:
“My confidence is rising quite rapidly that this is, in fact, becoming the fourth, real McCoy, bubble of my investment career.”
Grantham didn’t consider the equity market to have the attributes of a bubble in February.
Second-guessing how far a bubble can rise is a fool’s errand. Bitcoin went to 20,000 when many thought that it had gone too far at 2,000. The Fed looks like it is too scared to let asset prices fall. Just how infinite is their balance sheet is anyone’s guess. The equity market has been ebbing and flowing with the rate of change of their balance sheet and they still appear to be primed at the pump.
We may not currently know the tenacity of the retail investor. We may not know the determination of the Fed to backstop risk assets. We may not know the speed with which corporate buybacks can return to the market.
What we do know, however, is that the higher the equity market goes, the worse will be the outcome for future growth, productivity, and the overall health of the economy.