Setting The Stage for The Next Collapse
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 20th July 2014.
When the central bank pumps money into the economy and suppresses interest rates it creates incentives to speculate and invest in ways that would not otherwise be viable. At a superficial level the central bank's strategy will often seem valid, because the increased speculating and investing prompted by the monetary stimulus will temporarily boost economic activity and could lead to lower unemployment. The problem is that the diversion of resources into projects and other investments that are only justified by the stream of new money and artificially low interest rates will destroy wealth at the same time as it is boosting activity. In effect, the central bank's efforts cause the economy to feast on its seed corn, temporarily creating full bellies while setting the stage for severe hunger in the future.
We witnessed a classic example of the above-described phenomenon during 2001-2009, when aggressive monetary stimulus introduced by the US Federal Reserve to mitigate the fallout from the bursting of the NASDAQ bubble and "911" led to booms in US real estate and real-estate-related industries/investments. For a few years, the massive diversion of resources into real-estate projects and debt created the outward appearance of a strong economy, but a reduction in the rate of money-pumping eventually exposed the wastage and left millions of people unemployed or under-employed. The point is that the collapse of 2007-2009 would never have happened if the Fed hadn't subjected the economy to a flood of new money and artificially-low interest rates during 2001-2005.
Rather than learning from prior mistakes, that is, rather than learning from the fact that the use of monetary stimulus to mitigate the effects of the 2000-2002 collapse led to a more serious collapse during 2007-2009 and a "lost decade" for the US economy, the 2007-2009 collapse became the justification for the most aggressive monetary stimulus to date. The damage wrought by previous attempts to artificially stimulate has resulted in the pace of economic activity remaining sluggish despite the aggressive monetary accommodation of the past several years, but it is still not difficult to find examples of the mal-investment that has set the stage for the next collapse. Here are some of them:
1) The suppression of interest rates has prompted a scramble for yield, which has pushed yields on higher-risk bonds down relative to yields on lower-risk bonds. The bonds issued by the governments of Spain and Italy now yield only slightly more than US Treasury Notes, the yields on investment-grade corporate bonds are now roughly the same as the yields on equivalent government bonds, and the yields on junk bonds are generally much lower than normal relative to the yields on investment-grade corporate bonds. This tells us that monetary accommodation has greatly increased the general appetite for risky investments, which is always a prelude to substantial losses.
2) Public companies have been buying back equity at a record pace, despite high equity valuations. One reason is that although equity valuations are high, debt is generally priced even higher. Regardless of how expensive a company's stock happens to be, from a financial-engineering perspective it can make sense for the company to borrow money to repurchase its own stock as long as the interest rate on its debt is lower than its earnings yield. Buying back stock boosts per-share earnings and often increases bonus payments to management, but it does nothing to expand or improve the underlying business.
3) The number of unprofitable IPOs during the first half of this year was the highest since the first half of 2000. What a waste.
4) The latest boom has been so obviously reliant on the Fed's easy money that the real economy's response has been far less vigorous than usual. This at least partly explains the reticence of corporate America to devote money to capital expenditure designed to grow the business and, instead, to focus on financial engineering designed to give per-share earnings a boost. IBM provides us with an excellent example. As David Stockman points out in a recent blog post, since 2004 IBM has generated $131B of net income, spent $124B buying-back its own stock and devoted $45B to capital expenditure. IBM has therefore been channeling almost all of its earnings into stock buy-backs and has bought back almost $3 of its own stock for every $1 of capex. Furthermore, 90% of the capex was to cover depreciation and amortisation. No wonder IBM has just reported declining year-over-year revenue for the 9th quarter in succession.
If interest rates were at more realistic levels there would be less incentive to buy back stock and more incentive to invest in ways to increase productivity.
5) Thanks to the combination of government support, low interest rates and a flood of new money, some large, poorly-run companies are staggering around like zombies, consuming resources that could have been used more productively. General Motors is a prime example.
6) On an economy-wide basis there has been no deleveraging in the US. This is evidenced by the following chart. Instead, the Fed's promotion of leveraged speculation and the government's deficit-spending maintained the steep upward trend in economy-wide credit. Consequently, in terms of total debt the US economy is in a more precarious position today than it was in 2007. It will therefore not be possible for interest rates to normalise without precipitating an economic collapse.
7) The abundance of cheap credit prompted hedge funds and private equity firms to buy more than 200,000 US houses, which in many cases are now being rented to people who lost their homes when the previous Fed-promoted boom turned to bust. This has boosted house prices and created the false impression that the residential real-estate market is immersed in a sustainable recovery, prompting new (mal-) investments in this market.
8) The strength in auto sales is linked to the ready availability of subprime credit, which, in turn, is an effect of central-banking largesse, making it likely that auto sales will tank within the next two years. This will not only affect the assemblers of cars and the manufacturers of the components that go into cars, but will also affect all the industries that are involved in the shipping, storage, selling and financing of new cars.
9) While there is no doubt that the shale oil-and-gas industry would have been a great success story without the flood of cheap credit engineered by the Fed, the flood of cheap credit has led to a massive increase in the industry's debt-to-revenue ratio that has probably made the economics of shale-oil production look better than is actually the case and made the industry acutely vulnerable to tighter monetary conditions. Consequently, despite its solid economic foundation there will probably be many bankruptcies within this industry over the next few years.
A final point is that just as you never really know who has been swimming naked until after the tide goes out, you will never be able to identify all the mal-investments until after the monetary stimulus comes to an end.
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