The Credit Strategist - October 2023
The monetary policy measures required to quell inflation are necessarily deflationary in nature. In order to lower prices, policymakers must destroy demand. Doing so in a global economy built on a foundation of debt rather than equity is treacherous because that debt must be serviced to prevent the system from collapsing. Virtually all that debt was created in a period of ZIRP/QE, meaning it carries extremely low costs that are now resetting much higher. Because asset values were established based on the low cost of the debt used to purchase and finance those assets, asset values must now be reset lower as financing costs rise significantly (not just by the 500-basis point rise in the benchmark rate but by much more in many cases because of credit quality deterioration). This situation creates a vicious downward cycle that is just starting to bite because higher interest rates work on a delayed basis as debt contracts don’t reset immediately. But as consumers, businesses and governments are learning to their dismay as we move deeper into the first full year of interest rates bearing a five-handle, the pain is real and inescapable. The fight against inflation is inherently deflationary and destructive; if it succeeds, it will slow demand which in turn will lower asset values, and if it fails then higher prices will do the work of destroying the value of financial assets.
Commercial real estate markets were the first to feel the pain of higher rates with properties in cities like San Francisco, Baltimore and Atlanta suffering price declines of as much as 75% from their previous sales. Now higher rates are starting to hit corporate credit markets as leveraged loan yields rise sharply. Private equity firms took advantage of pandemic-induced rock bottom rates to load their portfolio companies with low-cost debt. But now Fitch Ratings tells us that $270 billion of leveraged loans (in this $1.7 trillion market) carry weak credit profiles and are at risk of default. The Wall Street Journal reported that Petco borrowed $1.7 billion two years ago at 3.5% in the leveraged loan market; today those floating rate loans cost ~9%. Hanesbrands has $1.9 billion of bank borrowings at rates between 7.2% and 8.9% and is desperately trying to cut its debt while finding interest costs eating up most of its cash flow (in the most recent quarter, $75 million of interest expenses consumed almost all of its $78 million of free cash flow, which means the company had no free cash flow). S&P downgraded Hanesbrands to B+ from BB- last month while Moody’s Investors Service reduced Petco’s rating to B2 from B1. These higher interest costs and ratings downgrades are the tip of the iceberg in a world where interest rates are going to stay higher for longer.
Policymakers can slow down the inevitable collapse in economic activity and asset values but that is all they can do at this point with the federal deficit heading rapidly to $50 trillion, global debt well above $300 trillion, and the global economy’s productive capacity to service and repay that debt falling further behind every day. Much of that debt was unfortunately incurred for purposes that failed to enhance the productive capacity of the economy. Instead, it was used to stimulate consumption, housing and other economic activities that are unproductive and was priced at artificially low rates (i.e., rates suppressed by governments rather than set by market risk). Unless governments can keep mispricing money ad infinitum – which they can’t – there is no way to avoid the coming debt deflationary collapse. So eventually interest rates will move lower, but that will only be a result of economic distress, not successful central banking.
There are only three ways for governments to deal with their unpayable debts – default, inflation or currency devaluation (the latter are two sides of the same coin and can also be considered forms of default because they allow for the repayment of debts with devalued money). This means that one way to protect yourself is to own gold (I recommend 10-15% in a portfolio) which should rise as the value of fiat currencies deteriorate. But dealing with debt will take a long time and trigger serious social and economic disruptions as debt crowds out social, entitlement and military spending. There may still be a solution to this problem but not until a new generation of leaders is elected and those who so badly mismanaged the American economy over the last several decades are out of office.
The National Commission on Fiscal Policy and Reform (also known as the Simpson-Bowles Commission) that President Obama created in 2010 but never acted upon proposed a reasonable basis for moving forward but the situation is more dire today. I suggest we immediately appoint a bipartisan commission of non-politicians and non-academics to address our debt crisis. If we approach the problem in an objective way, we can formulate a series of practical steps to change the arc of insolvency on which America is set. Those in denial about the problem, or those who glibly say we can just keep printing our own currency, fail to acknowledge the growing risk that investors will lose confidence in the U.S. dollar at which point the cost of financing the deficit will rise to the point that it will trigger a crisis. Last month I titled this newsletter “This Is Later.” I should have titled it “It May Be Too Late.” We don’t have much time to get our act together. Based on the circus in Washington, it is probably already too late. Investors should act to protect themselves now because “later” is already too late if you own illiquid or overvalued assets. People need to act now when they can, not wait until they have to act when they won’t be able to do so.
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