Simply the Bust

Murray Gunn on May 26, 2023

Bankruptcies are rising, but the bond market still hasn’t got the memo.

Browsing the FT over my morning vanilla latte in the early summer sunshine today (you’re in Essex, not Rome, get on with it: Ed), my eyebrows were raised at an article titled, “U.S. credit squeeze triggers rise in corporate bankruptcies.” Eight companies in the U.S. with more than $500m in debt have gone to the wall this month (filed for Chapter 11 in the lexicon) which compares with a monthly average of only three in 2022 (a 2.618 multiple for those of you keeping track). Twenty-seven corporates identified as “large debtors” (over $500m in liabilities) have gone bankrupt so far this year and that compares with a total of forty in 2022. Clearly, the current deflation of money and credit is having an effect.

Last August, a car drove into the side of my motorcycle. I could see it about to happen and things went into slow motion. Then, bang. Back in 2007, I remember saying to my colleagues on the corporate debt desk at the Abu Dhabi Investment Authority, who were telling us every day that the markets had seized up, that it was akin to watching a car crash in slow motion. Sure enough, a catastrophic pile-up occurred in 2008. This seems to be a similar time.

S&P Global Ratings expect the default rate on speculative-grade bonds to nearly double into 2024, and yet our “downgrade-o-meter,” (the yield spread between the lowest-rated investment grade bonds and those one ranking above) remains stubbornly sanguine, indicating no concern at all about a corporate credit bust.

The chart below shows that the yield spread between junk bonds and those corporate bonds rated AAA has widened since its 2021 low, doubling at the peak in November 2022. However, compared with previous recessionary times, and we are almost certainly heading for another one, this gauge of corporate stress is nowhere near those previous extremes. If, as we anticipate, stock markets are set to decline again, expect corporate debt to become a huge issue.

Debt Stress Rising

Murray Gunn on May 25, 2023

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.

Debt Defaults Rising in U.K.

Murray Gunn on April 17, 2023

Yet more evidence that the credit crunch is underway.

The latest Bank of England Credit Conditions Survey was published the other day and provided a grim reading. It showed that banks and building societies (savings institutions) expect the supply of secured lending to plummet over the next three months whilst demand, particularly for remortgaging property, will rise.

Most worrying, perhaps, is that default rates are expected to rise sharply. The chart below shows that business loan defaults are expected to increase over the next quarter. The expectations for household loan defaults are even starker, with sentiment amongst lending institutions harking back to the days of 2008 and the Great Financial Crisis.

The FTSE 250 index, a broad barometer of U.K. business, peaked in September 2021 and declined into an October 2022 low. After a three-wave bounce retracing 50% of the decline, the index has now turned down again. This is a clear indication that the negative trend in U.K. social mood is continuing and could be set to intensify this year.

Croak! Defaults Starting to Accelerate.

Murray Gunn on March 31, 2023

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

Murray Gunn on March 27, 2023

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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