Creative Indestruction

Night of the Living Dead movie posterGeorge A. Romero knew how to make an entrance onto the Hollywood stage.

Night of the Living Dead, his 1968 directorial debut, set the ‘A’ standard for horror flicks. Though the special effects may seem unsophisticated to today’s moviegoers, the movie still terrifies modern day audiences.

The premise of the film has stood the test of time and been the subject of numerous sequels: The recently deceased find no peace in their graveyard slumber; they rise from the dead hungry to feast upon living human flesh. The film, produced on a shoestring budget of $114,000, follows a group of seven unlucky souls trapped in a rural Pennsylvania farmhouse, desperate to escape the fate that has befallen others who’ve succumbed to the grasp of the ravenous zombies.

It’s plausible that Romero had come across the work of Joseph Schumpeter before entering filmmaking. The phrase ‘creative destruction’ was coined by the Austrian American economist in 1942 and refers to what W. Michael Cox describes as “free market’s messy way of delivering progress.” Something new and innovative necessarily kills off the methodology it replaces, freeing an economic pathway to advancement. The absence of creative destruction, therefore, invites zombie industries to languish, feeding off healthy and more efficient new entrants and dragging down economic growth.

Think Eli Whitney’s cotton gin, which removed seeds from cotton in a fraction of the time it had taken to do so by hand. Imagine a world before the rise of railroads, in which horse drawn wagons were primarily responsible for transporting goods. Dare we go there? Close your eyes and picture what it would take to get through any given day with a rotary phone.

Feeling immeasurably more productive with that iPhone in hand? Then you understand creative destruction, what Schumpeter himself called, “The essential fact about capitalism.”

I suppose that makes quantitative easing and other central banking magic tricks like negative interest rates the essential executioner of capitalism. Look no further than the amount of U.S. industrial capacity that is up and running, or better put, fallow. At 76.5 percent, the rate of capacity utilization remains 3.6 percentage points below its average dating back to 1972.

A friendly reminder – the U.S. economy is technically 80 months into ‘recovery.’ Imagine how much better off we’d be if a little creative destruction would have been allowed to take hold.

It could be worse. We could be as overcapacitized as China’s industrial sector. Consider that cutbacks to production in the Chinese steel industry alone will result in some 400,000 layoffs. Tack on planned capacity reductions in China’s coal, aluminum and copper industries and you’re talking about reducing the Chinese workforce by the equivalent of Wyoming’s or Vermont’s entire population. Debt-fueled growth stories all tend to end the same, though China’s case is arguably one for the history books.

Many years ago, when my friend Oleg Melentyev was still at Bank of America Merrill Lynch, he wrote a report that haunts me to this day. In what I now realize was a channeling of Romero’s spirit, Melentyev warned that there would be repercussions for the default rate cycle of the Great Financial Crisis being cut short by the Fed’s extraordinary measures.

You will recall that step one on the road to ‘extraordinary’ entailed reducing interest rates to the zero bound, which the Fed did in December 2008. By then, there were multiple horror shows playing out in the financial markets. While the stock market bottomed in March 2009, with the Standard & Poor’s 500 hitting a devilish 666-level before rebounding, the bloodbath in the bond market continued through year end.

Companies were meeting their makers right and left. The default rate, which tracks the percentage of issuers reneging on their promised interest payments, was careening skywards and would eventually top out at 13.1 percent, according to Moody’s Investors Service. The rate was a barely discernible one percent two years earlier. Looked at through a slightly different prism, the dollar volume of defaults ended 2009 at 16.8 percent.

The what-happens-next is what so troubled Melentyev at the time. The default rate tumbled 10 percentage points, ending 2010 at 3.2 percent, while the dollar-volume rate crashed to 1.6 percent. (No, Virginia, that is NOT normal.)

For all of the analyst communities’ concerns about the inability to refinance all of this junky debt over the past few years, cheap money has managed to tear down each and every so-called ‘wall of maturity.’ Such is the reality of a world without yield in safe places.

A glance at issuance volumes doesn’t begin to suggest there was a recession underway, much less one that was ‘Great.’ Though growth slowed for a moment between 2007 and 2008, the siren call of zero interest rates that led off 2009 all but commanded investors back into the bond market.

The high yield bond market has doubled in size not once, but twice, since the start of this young century, hence the tendency for it to implode under its own weight. Outstandings doubled from 2000’s $334 billion to end 2007 at $674 billion. Then came the pause. The high yield market ended 2008 at $675 billion, up a mere billion over the prior 12 months.

Then it was off to the races. Issuance has since redoubled the size of the junk bond market to $1.5 trillion, with a capital ‘T.’ If you include all of the debt on high risk borrower balance sheets, including institutional facilities, term loans and credit lines outstanding, you’re talking about an additional $2 trillion.

“The high yield market and leveraged loan market has continued to grow,” worries Moody’s Tiina Siilaberg, “and the covenants are much looser now than they were in 2007. The default cycle this time around will be much different.”

As things stand, investors are being reminded in rude form how closely linked the behavior of risky debt and the stock market are. According to Melentyev’s latest tally, the spread, or the extra compensation investors receive for holding junk bonds vis-à-vis Treasury bonds, is nearly eight percentage points, the most since the fall of 2011.

“All-in high yield spreads today…are at their widest point since the depths of the Great Financial Crisis in 2009,” Melentyev cautions.

To his credit, Melentyev has never been one to buy into the dire need to net out energy borrowers to get the true underlying health of the bond market. After all, no analyst was doing this when oil issuance was going haywire and benefitting investors. If you must, junk spreads ex-energy have another percentage point to go in terms of widening and worsening before reaching their 2011 wides.

By the looks of things, investors won’t have to wait too long. Six of the ten issuers Moody’s downgraded in January to the category least-likely-to-be-able-to-refinance-their-debts were companies outside the atrophied energy sector. Overall stress, as gauged by the credit rating agency’s Liquidity Stress Index, spiked to 7.9 percent from 6.8 percent in December, the highest since December 2009 and the biggest one-month leap since March 2009.

Where’s the real worry? If you do play the neat netting game, but in a fair manner, removing financial issuers, which were a massive drag on the market, AND energy borrowers, which flattered the figures, investment grade is trading at its widest since 2011.

In other words, on a relative basis, junk is actually outperforming its hoity-toity investment grade big brother. It’s tomorrow’s fallen angels, or downgrades to junkland, that should give investors fright. At $5.3 trillion, it’s over three times the size of the high yield market. But that’s such a big story on its own, it merits its own sequel.

Of course, the Fed could truly be on the path to normalizing interest rates, which would give investors license to pull the plug on zombie companies once and for all, and allow Schumpeter to finally slumber peacefully in his ***own*** grave. What are the odds of that happening?

Investors would do well to listen to one of Wall Street’s most experienced voices, UBS’ Art Cashin, on those prospects. Cashin is sticking by his call that we’ll see zero before we see one percent interest rates care of a frightened Fed that backtracks on its ill-fated and two-years-overdue initial interest rate hike.

The next stop? That would be negative interest rates according to the dangerous theorists running the world economy.

Japan certainly seems to have bought into the notion that negative interest rates will prove to be the palliative they’re in desperate need of after 25 years of failed monetary policy. Japan’s inauguration to this sad group brings the total amount of global sovereign debt trading at negative yields to $5.5 trillion. Punctuating the implications for future countries dragged down the same path to negativity: The Japanese government has just canceled its next 10-year sovereign debt auction.

Can you imagine Uncle Sam going that same route – cancelling a Treasury auction because the 10-year was trading with a negative yield? If you answered ‘yes,’ you’re clearly comfortable co-existing with the corporate zombies in our collective midst.

Whistling Past the Junkyard

To this day, I still count by the flash of lightning and the thunderclap to guesstimate a storm’s distance. To this day, I make sure all trees are trimmed to be absolutely positive they’re clear of any window in my home. Such is the impression Poltergeist left on yours truly’s psyche back in 1982. For those of you who need reminding, Robbie, the name of the character who played the son in Poltergeist, would count the seconds between the lightning and the crashes of thunder for comfort knowing that the longer the pause, the more distant the storm. In the end, as the unsettled spirits rose through the floorboards beneath which they were buried, the time spans grew frighteningly shorter, culminating in Robbie’s being snared right out of his bedroom by a possessed tree. Though Robbie was rescued from the storm’s grasp, his fictional sister Carole Anne was not so lucky. The demons in the TV grabbed her very body and soul and didn’t let go until her determined mother went into the netherworld to get her back.

For the credit markets, the storm sounds as if it’s closing in. In a genuinely spooky “They’re here” moment, just last week, Zerohedge broadcast the news that the UBS Managed High Yield Plus Fund had announced it would be nailing the doors shut and liquidating their holdings. Slowly. The doomsday blog warned that the illiquidity Minsky moment was finally knocking on hell’s door; big banks’ bond inventories have been decimated and funds’ ability to liquidate in an orderly fashion would be stress-tested and fail. Forget for a moment that UBS is also the name associated with the first stressor to emanate from the burgeoning subprime crisis. This fund, which opened to investors in 1998, had survived both the dotcom bubble bursting and the credit collapse that accompanied the subprime crisis.

There’s no doubt the time should be nigh. Credit spreads, a measure of the extra compensation over Treasurys investors command for the risk of taking on corporate credit risk, for both high grade and junk bonds have gapped out in recent months. Investors are now demanding seven percentage points above comparable maturity Treasurys to hold the riskiest credits, the most in three years. Though nowhere near their post-crisis highs that exceeded double-digits, spreads are nonetheless flashing red. They’re cautioning investors that the distress emanating from commodity-dependent global economies and signs of a slowing U.S. economy could create enough turbulence to derail one of the most glorious credit cycles in the history of mankind.

Aside from macroeconomic indicators, what exactly are spreads tuning into? A recent report by Deutsche Bank’s Oleg Melentyev, whom I’ve known long enough to spell his last name by heart, suggest that the stage is set for the next default cycle. For starters, the current credit cycle is pushing historical boundaries. Going back to the 1980s, high-yield debt creation waves have lasted between four to five and a half years resulting in 53-68 percent debt accumulation from the baseline starting point. Where are we in the current cycle? Over the past four and a half years, junk credits have tacked on 55 percent growth when you take into account the combination of bonds and leveraged loans on bank balance sheets, putting the cycle, “comfortably inside the range of previous cycles,” according to Melentyev.

But that’s just one omen. Issuance aggressiveness is another way to test the credit cycle winds. Cumulative credit cycle issuance volumes of companies rated CCC and below, the junkiest of the junk, half of which can be expected to default over the next five years, casts a light on investors’ true pain thresholds. The mid-1990s and the mid-to-late 2000s saw highly toxic issuance swell by 20- and 18-percent, compared to the current cycle’s 17 percent.

Melentyev hedges the two metrics’ signals with the caveat that he’s using 2011 as a starting point despite clear evidence that the markets were expanding by the latter half of 2010. Erring on the conservative side, in other words, leads him to the ominous conclusion that, “the pre-requisites for the next default cycle are now in place.” Pre-requisites, though, do not make for certain outcomes though other fundamental benchmarks validate Melentyev’s premise.

At the most basic level, companies reassure bond investors by demonstrating they can cover the coupon they’ve promised can be clipped. The higher a company’s credit rating, the greater the probability the firm can make good on its commitment. The question is, what does it say when the presumptive pristine credits that populate the investment grade universe, the ones who disdainfully look down their noses at their lowly junk-rated brethren, begin to emit signs of balance sheet stress? The ratio of debt-to-earnings before interest, taxes, depreciation, amortization and whatever else is left in the kitchen sink for this superior cohort rang in at 2.29 times in this year’s second quarter. That tops the 1.91 clocked in June 2007 before the onset of the financial crisis. So a less cushioned starting point – that is, if this is the starting point and the storm really is fast approaching.

There are plenty of guideposts that indicate we haven’t yet arrived at the beginning of the end. Topping the list is the furious merger and acquisition (M&A) activity dominating the news flow. At $3.2 trillion globally, 2015 was already on track to take out the 2007 record of $4.3 trillion in M&A volume. And then the big guns came out. Michael Dell’s ambitions as a private market tech mogul became crystal clear with the announcement that Dell, partnered with Silver Lake, would take out EMC in a $63 billion transaction that requires at least $40 billion in debt to finance. The kicker is that $15 billion would be junk bonds – the biggest of its kind in history.

To not be outdone, Anheuser-Busch InBev muscled in to buy SAB Miller with a sweetened $106 billion offer giving new meaning to “This Bid’s for You!” As for the financing to consummate this tie-up? A cool $70 billion in debt financing, a figure that tops Verizon’s one-for-the-history-books $49 billion in bonds that helped pay for its acquisition of Vodafone.

In the event these figures have induced a bit of debt indigestion or indignation, rest assured, Standard & Poor’s (S&P), that other mighty credit rating agency, is on the case. In the first nine months of the year, S&P downgraded companies 297 times, the highest pace since that dark year 2009, with liquidity in the bond market one-tenth what it was, caveat clearly emptor.

And yet…there’s that sticky issue of the dumb money that’s on the prowl. This is not some reference to a pile of mutual fund “money on the sidelines,” which history has proven can be as ephemeral as a poltergeist you wrongly conclude has been exorcised. Nope – we’re talking about brand-new allocations to the credit markets.

Brian Reynolds of New Albion Partners, whose name has graced these pages in the past, helpfully keeps a real time score of the number of public pensions allocating fresh funds to the credit markets since August 2012. His most recent reckoning: 782 votes amounting to $169 billion in new monies being put to work in credit funds. Assuming a conservative five times leverage (which beats the 10-50 leverage multiples deployed in pre-crisis days), some $1.2 trillion in new credit flows have goosed the debt markets since late 2012.

What, pray tell, do stock market gyrations the likes of which we’ve seen since August do to pensions’ collective pain thresholds? In a nutshell, it strengthens their resolve to diversify, diversify, diversify away from their stock market exposure. August, September and the first half of October have set a three-month record for new pension allocations. Taking the cake in the “you-just-can’t-make-this-stuff-up” category, the Louisiana Firefighters’ pension is putting $50 million to work in an unconstrained fixed income fund; the funding will be sourced from an equity fund liquidation. On second thought, maybe it’s a good thing they’ve got access to plenty of firehoses.

Looking ahead, Moody’s high yield soothsayer Tiina Siilaberg, (I can spell her name from memory as well), sees clear evidence that refunding risk is building in the pipeline. Tiina’s barometer is the credit rating agency’s proprietary index that gauges the future ability of companies to roll over their maturing debt in three years’ time. The last time this indicator was at its current level was in the depth of the 2009-2010 credit crunch. “A significant contributor to the decline in the index is the increase in upcoming maturities. We currently expect $109 billion of speculative-grade bonds maturing over the next three years vs. $88 billion at the beginning of this year.” Indeed, refinancing volumes are down by some 37 percent over the last year.

Eric Rosenthal, at Fitch, which rounds out the Big Three credit rating agencies, foresees some messiness in the statistics to come thanks to the degradation of issuer balance sheets coupled with the less-than-friendly refinancing landscape. Rosenthal, whose last name practically spells itself, now expects the corporate bond market default rate will end the year around 3.5 percent and keep moving up in 2016. This rate, he cautions, is materially higher than the 2.1-percent average rate that coincides with non-recessionary times. In an conscious nod to $45 oil, nearly half the energy and metals & mining issues are trading below 80-cents on the dollar (par is 100-cents) compared to seven percent for the whole of the high yield universe. Still, the beat goes on, Rosenthal concedes – which is good news for Michael Dell. Issuance may be down 35 percent over last year for the aforementioned beleaguered commodities space but it’s up three percent for the rest of the junk market.

Are the conditions for a meltdown in the bond market firmly in place? Are investors deluding themselves, whistling past the junkyard? Absolutely. But that shouldn’t necessarily keep you up at night, counting the seconds in between lightning flashes and thunderclaps. Or, as Deutsche Bank’s Melentyev’s quips, “A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so.” By that same token, Poltergeist’s greedy real estate developer could have ponied up the extra moola to move the coffins of the dead and buried under the subdivision he so profitably erected. Instead, he rolled the demonic dice and simply removed the headstones, whistling past the houses until the unsettled corpses rose through the floorboards, shattering the illusion of suburban serenity.