With rising interest rates, debt seems as good a candidate as any to cause the next downturn. How severe?
It depends on the rate and severity of interest rate hikes and inflation. It could be drawn out or sharp. My Magic 8-Ball doesn’t have the answer and neither do I.
None of this exists in a vacuum either. Interest rates, inflation, asset prices exist in a web of factors where changes in one have a multitude of possible effects on the others. And then you add humans to the mix. Spending a ton of energy trying to figure out what happens next seems like a wasted endeavor. But that’s just my take on it.
Besides, this post has more to do with where we are in the credit cycle, so we better understand the risks.
Howard Marks, in a 2001 memo, broke down the credit cycle like this:
The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.
The process is simple:
- The economy moves into a period of prosperity.
- Providers of capital thrive, increasing their capital base.
- Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
- Risk averseness disappears.
- Financial institutions move to expand their businesses – that is, to provide more capital.
- They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction — that is, to investment of capital in projects where the cost of capital exceeds the return capital, and eventually to cases where there is no return of capital.
When this point is reached, the up-leg described above is reversed.
- Losses cause lenders to become discouraged and shy away.
- Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
- Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.
- Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
- This process contributes to and reinforces the economic contraction.
Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.
Higher interest rates bring higher interest payments, all else equal. Higher payments equal higher costs that put pressure on profit margins and profits for those companies that actually earn profits.
Keep in mind, debt is not alone in adding higher costs at the moment. Wages are another. Inflation on commodity prices would be a third contributor. To be fair, lower corporate taxes help offset some of it, though.
But not to worry, the companies with good profits will be fine. So they make a little less money in the short term. Higher sales or a slow down in hiring (or layoffs) or higher prices on products will offset it in the long run.
But since the market is short-term focused, lower profits and profit margins will impact stock prices at some point.
The bigger issue might be this. Cheap debt brings the temptation to overborrow in the hopes of faster business growth.
It doesn’t always work out that way. There’s a point where borrowing additional money produces low or no additional business growth. As Marks says, it “leads to capital destruction.”
Still, that debt has to be paid back or rolled over to avoid bankruptcy (issuing shares to cover the debt is the third option). Rolling over the debt means a higher cost to borrow.
How many companies used debt to accelerate growth but don’t have the cash flows to cover the higher costs? I can think of a few because it always makes for a great story stock.
The problem with story stocks is they eventually face a moment of truth. Either the story becomes reality or they crash and die.
Then there are the companies that took on debt to buy back stock. It was a great idea for the companies that could afford it and bought shares back at undervalued prices. But could they all afford it? Nope. Did some overpay? Absolutely.
The number of companies reissuing shares in the next year or three will answer the first question, at least. The market rarely looks kindly on share dilution.
Putting it all together, my two cents is that last year was the peak of the cycle and now we’re moving past it. Now is not the best time to be greedy with companies fitting those last two examples. It’s also not the time to chase attractive junk bond yields, since they’re getting hit by interest rate risk and credit risk at the same time.
As Howard Marks would say, knowing where we are in the credit cycle is an important thing because we’re better able to understand the potential risks.
Marks Memo: You Can’t Predict. You Can Prepare. (pdf)
- Debt, Loans, & Credit Quality: The Devil is in the Details – F. Martin
- Are Buybacks Really Shortchanging Investment? – HBR
- Lawmakers Don’t Understand How Stock Buybacks Work – B. Carlson
- Peak Quality? – Albert Bridge Capital
- Finding Your Cello – R. Thaler
- Inside the Strange Odyssey of Hedge Fund Kind Eddie Lampert – Vanity Fair
- The Key to Good Luck Is an Open Mind – Nautilus
- Does My Algorithm Have a Mental-Health Problem? – Aeon
- Everything is Terrible: An Explanation – Tech Crunch