Last week the S&P 500 and the Dow Jones Industrial Average (DJIA) continued their upward trend toward all-time highs as it was announced that the US and China have reached a “phase one” trade deal between the two countries. The deal helps ease tensions and nudges China towards becoming a better trade partner with the US, giving investors confidence in future economic growth.
Or at least, that is the prevailing narrative ascribed to the current stock market rally.
In an article titled “The Fed Won’t Avert the Next ‘Crisis’…They Will Cause It,” Zero Hedge, a “markets-focused” blog, describes how the Fed’s policy of low interest rates has led to all-time highs in equity markets. It crystallized my views on what’s going on with stocks, and it is so good I’d like to highlight a few passages.
It begins by quoting author John Mauldin, who served as CEO of the American Bureau of Economic Research. “Yes, we did indeed need the Federal Reserve to provide liquidity during the initial crisis. But after that, the Fed kept rates too low for too long, reinforcing the wealth and income disparities and creating new bubbles we will have to deal with in the not-too-distant future. This wasn’t a ‘beautiful deleveraging’ as you call it. It was the ugly creation of bubbles and misallocation of capital.”
It points out the rising levels of “non-productive debt” and how it has negative long-term economic consequences. “Non-productive debt” detracts from economic growth since servicing this debt diverts income from productive investments and leads to a “diminishing rate of return” for each new dollar of debt.
Total System Leverage, which includes government debt, corporate debt, household, margin, bank debt and student loans, totals about $74 trillion, and has risen almost in lockstep with the S&P 500 price index. Why is that?
Normally, share buybacks are used by corporations to return cash to shareholders and is a way to deploy capital when no better options are available. However, with the current low-interest rate environment, companies have been taking advantage of “easy money” and have been repurchasing shares to increase earnings per share, increasingly because stock-based instruments make up the majority of executives’ pay and short-term buybacks increase stock prices. “Just in the last two years, corporations have issued another $1.2 trillion of new debt NOT for expansion, but primarily used for share buybacks.”
The article then points out that inflated asset prices have created an illusion of economic strength and stability. If this is the case, then why did the Fed cut rates three times last year? Additionally, when a downturn does occur, what tools will the Fed have at its disposal if its usual method for stimulating the economy, cutting interest rates, runs out of ammunition? Where do you go when you’re already at or near zero?
When an unanticipated exogenous event occurs, it will serve as a catalyst for weaker economic growth, declines in corporate earnings, and defaults of companies unable to service the debt they’ve taken on. As mentioned in the article, “in just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion- an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.” Additionally, as Zero Hedge has previously noted, “there is a large tranche of BBB bonds on the verge of being downgraded to ‘junk.’ When this occurs, there will be an avalanche of selling as pension, mutual, and hedge fund managers dump bonds simultaneously into what will be an illiquid market.” In short, corporate bonds will be decimated.
So, as the article states, “the Fed won’t avert the next ‘crisis’…they will cause it.