Drowning in Debt

Murray Gunn on June 30, 2023

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.

U.K. House Price Deflation

Murray Gunn on June 12, 2023

It looks set to deepen.

The latest data on British property shows that deflation is now official. The Halifax House Price Index, a popular barometer of the health of the U.K. property market, declined by 1% on an annualized basis in May. This is the first annualized contraction since 2012 when Britain was still recovering from economic recession and the Great Financial Crisis.

The change in sentiment has been dramatic. In June 2022, the Halifax index was accelerating at a 12% annualized clip, but the combination of an emerging negative social mood and the lagging impact of rising interest rates has seen rapid disinflation, which has now turned to deflation. Judging by the share prices of a two major real estate companies in the U.K., the pressure on property values is likely to deepen.

A distinct triangle pattern can be seen in the share price of Hammerson plc, a major British property development and investment company. We label that as wave (4) of a decline that started all the way back in 2015. We anticipate a decline in wave (5) to unfold from 30.81p.

Rightmove plc is the company which runs Britain’s largest online real estate property portal. Back in March 2022, we anticipated that the decline which started in January of that year was not over. Subsequent price action reveals that the decline is likely to be ongoing from 592.20p.

A protracted slump in the U.K. property market seems increasingly likely.

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 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.

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