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.

U.K. House Price Deflation

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

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

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.

Crunchety Crunch

The credit crunch continues.

The European Central Bank published its Euro Area Bank Lending Survey (BLS) for the first quarter this week and it provides further evidence that the supply of, and demand for, credit is drying up. This is the headline paragraph from the report:

“In the April 2023 BLS, euro area banks indicated that their credit standards for loans or credit lines to enterprises tightened further substantially in the first quarter of 2023. From a historical perspective, the pace of net tightening in credit standards remained at the highest level since the euro area sovereign debt crisis in 2011. The tightening was stronger than banks had expected in the previous quarter and points to a persistent weakening of loan dynamics. Risks related to the economic outlook and firm-specific situation remained the main driver of the tightening of credit standards, while banks’ lower risk tolerance also contributed. The tightening impact of banks’ cost of funds and balance sheet situation on credit standards for loans to firms remained contained and broadly unchanged compared with the previous quarter. In the second quarter of 2023, euro area banks expect a further, though more moderate tightening for loans to firms.”

Lending standards also continued to tighten for housing and consumer loans, whilst demand for loans continues to drop with higher interest rates the main factor cited.

So, the ECB should be happy, right? This is what it wants to slow the economy and curb the rate of change in consumer prices. This, plus the stable consumer price inflation figures for April, will probably mean the ECB only hikes its policy interest rate by 25-basis points tomorrow. A 50-basis point hike would now be a shocker.

The thing is, though, the ECB cannot control what risk committees in commercial banks are thinking. The histogram in the chart below shows the net percentages for responses to questions related to contributing factors in relation to decisions on lending standards. This is defined as the difference between the percentage of banks reporting that the given factor contributed to a tightening and the percentage reporting that it contributed to an easing.

We can see that it is overwhelmingly risk perceptions and tolerance which drive decisions on lending standards, and with corporate credit spreads yet to really widen, the worst of the downgrade and default cycle looks to be still ahead of us. Money market futures are already pricing in an interest rate cut from the ECB by the middle of next year. If, as we suspect, stock markets continue to decline, that pricing of cuts will very likely be brought forward in time.

Credit Deflation

The motor of the economy has stopped.

Two reports on Bloomberg caught my eye this week. Firstly, U.S. home foreclosures have now increased on an annualized basis for 23 straight months, as the housing market comes to terms with the unprecedented rise in interest rates over the last couple of years. Secondly, auto repossessions are booming as consumers fall behind on loan payments. In a stark reminder of the phrase, “there’s always a bull market somewhere,” the report describes the optimism and ebullience at the North American Repossessors Summit, held near Disney in Orlando and with the stomach-churning strapline, “Putting the Magic Back in Repossessions”. Seriously. Check it out at reposummit.com.

Everywhere you look now, higher interest rates are beginning to bite. It seems increasingly likely that another round of bank consolidation is underway in the U.S. with many regional banks facing difficulties. The U.S. is unique in the world by having well over three thousand banks whereas most countries have less than three hundred. Smaller banks are losing deposits and people are moving to the big players. Mergers and closures seem inevitable, and that has an effect on the availability of credit. The decision to fund a tech venture capital firm, being made by SVB a few weeks ago, is now in the hands of an official at HSBC, a potentially very different model. Everyone in the market seems to be getting excited about the next Loan Officers Survey from the Fed due out next month but we don’t have to wait for that to recognize that the credit crunch is already in operation.

The chart below shows that U.S. Commercial Bank Credit is now contracting. The last time credit deflation was this extreme was during the Great Financial Crisis of 2008-09. Given that, in Elliott wave terms, the current bear market is probably one degree larger than that episode, do not be surprised if this contraction in credit persists.

Debt Defaults Rising in U.K.

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.

Le Crunch

A credit crunch is upon us.

2023 is fast becoming the year in which the stark realities of the end of the easy money era are becoming visible. There was already evidence that lending was being curtailed but the recent banking wobbles have exacerbated the process.

The chart below shows the amount of loans and leases in bank credit from U.S. commercial banks. The series has just witnessed the biggest two-week drop in the history of the series going back to 1973. The contraction in credit was across all sectors, from real estate to commercial and industrial loans.

In Europe, the last bank lending survey from the European Central Bank showed that banks tightened lending standards by the most since 2011. That was in the last quarter of 2022 and it’s very probable that the lending has been even more curtailed in the first few months of this year.

In the U.K., meanwhile, 56,000 2-year fixed rate residential mortgages are due to expire this summer leaving borrowers with much higher rates when they re-set. Expect to see consumer demand dampened as a result.

The shock of tighter money is really only just beginning.

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?

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