Drowning in Debt

Before a tsunami hits, the tide recedes dramatically.

Warren Buffett famously said that “when the tide goes out, you can see who has been swimming naked,” in reference to companies and investors who are over-leveraged when events turn against them. The tidal cycles on the river Thames here in England remain as predictable as they ever were, but for Thames Water, the utilities company, the tide has most definitely gone out and now the board can be seen in the altogether.

Water companies in the U.K. were privatized under the Thatcher government in the late 1980s and almost all have since been delisted and taken into ownership by private equity firms. Macquarrie Group, the Australian financial services company, took over Thames Water in 2006 and during the “free-money era” after the Global Financial Crisis, when interest rates went to almost zero, built up a humongous pile of debt.

Productive debt, such as that used for investment, can be a good thing, but unproductive debt is not. Under Mcquarrie’s ownership, Thames Water used the debt to help pay out billions in dividends. The result was that by last year Thames Water was operating under a leverage ratio of 80%, meaning that its debt amounted to 80% of its capital. Now, as the tide has receded and interest rates have shot up, Thames Water is essentially bust, and the U.K. government is considering taking it back into public ownership. The chart below shows the price of one of Thames Water’s bonds, now trading around 50 pence on the pound. Notice that the price was declining relentlessly before the drama of this week, giving a warning that something was not quite right.

This is simply a classic tale of what happens when debt becomes unsustainable. Expect a tsunami of stories like this to emerge as interest rates stay high and highly leveraged companies are forced into debt deflation.

Debt Stress Rising

Signs of a breaking point coming.

Most people thought Ben Bernanke was joking when, in 2002, the former Fed Chair said that, in an effort to fight an economic downturn, the Fed could throw money out of helicopters. Fast forward to 2020 and that’s exactly what happened, well, metaphorically at least, when the U.S. government sent households so-called stimulus checks. Thanks to this largesse, the supply of money exploded. Then, from 2021, so did consumer price inflation. The Fed and the government seemed surprised. Seriously, what the non-fungible tokens did they think was going to happen?!

It was Milton Friedman, the most famous monetary economist, who first coined the term helicopter money and the last couple of years have proven his thesis that, “(consumer price) inflation is always and everywhere a monetary phenomenon,” largely correct. Ironically, it is the current consumer price inflation which the Fed had a huge hand in creating, that is a big reason why a spectacular economic bust is coming.

Social mood is the driver of economic cycles, and it has been turning ever more negative since the start of 2022, driving stock markets lower. At the same time, rampant consumer price inflation is causing people to turn to credit card debt to keep their heads above water. The latest household debt report from the Federal Reserve Bank of New York shows that U.S. credit card debt remained at a record high of $986 billion in the first quarter of 2023. The interesting aspect about this stat is that credit card debt historically gets paid down in the first quarter of the year. Not this year, no Sir. It’s another sign that, with the personal savings rate at historic lows, people are borrowing in order to merely exist.

But look at the chart below. Delinquency rates (those not paying for greater than 90 days) had fallen to a record low when the stimulus checks fell from the great money gods in the sky, but they are now accelerating higher as people struggle to make payments. This is yet more evidence that a recession is coming which will probably coincide with debt deflation.

Powell’s Burns Moment Cometh

The Fed Chair is probably haunted by the ghost of Arthur Burns.

The current bout of accelerating consumer prices that we are living through has brought back analyses and debate about the 1970s and how a similar problem was solved. Credit is wholeheartedly given to Paul Volcker who, at 6 foot 7 inches tall and regularly chomping a stogie, inevitably became known as the “hard man” of Fed chairs as he raised the Fed Funds interest rate to a 20% high by 1980. Consumer prices then disinflated for decades until now.

Putting aside the fact that we do not think the Fed chair, or the Fed Funds rate can influence the waxing and waning of consumer prices to any great extent, the person in charge of the Fed two-before Volcker will probably be in the forefront of, current-chair, Jay Powell’s thoughts right now.

Arthur Frank Burns was an American economist and diplomat who served as the 10th chairman of the Federal Reserve from 1970 to 1978. The annualized change in consumer prices in the U.S. had risen from around 2.5% in 1972 to over 10% by 1974. Led by Burns, the Fed had raised the policy interest rate from 4.5% to 13% over the same period.

But then came the slump in 1974. Having peaked in 1973, the Dow Jones Industrial Average had plummeted by 46% into a low in the last quarter of 1974. Spooked, the Burns Fed cut interest rates back to below 5% and, to be fair, consumer prices started to disinflate. By 1976, though consumer prices were accelerating again, moving back above a 10% per annum clip in 1979. Enter the big man, Volcker, who sealed his legendary status by slaying the “inflation” dragon.

The historical narrative is that Burns is pilloried for cutting interest rates in the mid-1970s, in so doing fueling the subsequent re-acceleration in consumer prices. For better or worse, his legacy is of being known as “the worst chair in Fed history.”

Powell, whose approval ratings are already the lowest since the Greenspan Fed over twenty-years ago, is very likely going to face a similar situation to Burns if our Elliott wave analysis is correct, the stock market (and economy) tanks and debt deflation sets in.

What will he do? As Elliott Wave International’s subscribers are aware, the Fed will follow (not lead) what the money and bond markets are pricing in, so stay tuned to keep on top of developments.

Croak! Defaults Starting to Accelerate.

Debt deflation is happening.

You know that terrible apologue about the frog in a pan of boiling water? Putting aside what kind of brain thought that up in the first place, the point of the story is that the frog doesn’t know it is being boiled alive until the point of its demise. This came to mind when I was thinking about what is going on in financial markets.

The relentless rise in bond yields and interest rates since 2020, accelerating last year, has been akin to the boiling water. One frog in this metaphor was Silicon Valley Bank and, of course, there are others. All of a sudden, it seems, companies are realizing that the water has been boiling for some time.

The December 2022 issue of the Elliott Wave Financial Forecast highlighted the fact that so-called zombie companies, those that can’t produce enough cash to service their debt, have proliferated since 2020. Zombies now account for 24% of the Russell 3000 stock market index (almost a quarter!). The previous peak was 16% during the dot.com bust at the start of the century.

Now, evidence is emerging that debt deflation is starting to ramp up. The chart below shows that corporate defaults have zoomed higher in the first two months of this year and are now at the fastest year-to-date clip since 2009. Credit rating agencies have, shall we say, a ‘checkered’ past but the 12-month average of the number of credit downgrades is sloping up, meaning that the trend is toward deteriorating credit quality. And corporates face a wall of refinancing to be negotiated over the next couple of years.

2023 is fast becoming the year in which people realize that the cost of money and debt has changed, and is not returning to the easy days of the past. Hey, do you smell something cooking?

This is What Debt Deflation Looks Like

Expect confidence in corporate bonds to plummet.

Normally sleepy Switzerland was the center of attention last week after the shotgun wedding between Credit Suisse and UBS. Both banks didn’t want the deal but the Swiss regulator, Finma, insisted on it taking place, even going so far as changing the law and not allowing UBS shareholders to vote on it. Not only that, Finma changed the capital structure, with Credit Suisse bond holders being wiped out as prices have been written down to zero. Normally, bond holders are first in line to get at least some of their money back.

The so-called Additional Tier 1 (AT1) bonds, also known as contingent convertibles (CoCo), were born in 2013 as European banks began looking for ways to boost their capital ratios. It is widely known that AT1 bonds are risky and that if a bank gets into difficulties the bonds could get converted into equity or written down completely. Nevertheless, the wipe out of Credit Suisse AT1s has come as a shock to the system and now other bank AT1 bonds are being re-priced. This increases the cost of capital in the banking industry as a whole and will contribute to a general tightening of monetary conditions and lending standards.

This is what debt deflation looks like. Bonds become worthless. Sure, the AT1 bonds are a unique form of debt, but underlying all bond markets is confidence. The term credit is derived from the Latin word cred which actually means “believe.” When belief or trust goes, things can get very ugly as was aptly demonstrated by the financial crisis of 2008.

We have highlighted the fact that the corporate debt market has held up relatively well in the bond bear market thus far, but that we expected it to be the next shoe to drop. The Credit Suisse bond situation is a manifestation of that and we anticipate the disappearing confidence to drive corporate bond yield spreads wider. As the chart below shows, European corporate debt has a lot of scope to underperform.

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