The quarterly outlook for credits: zombies or creative destruction

The quarterly outlook for credits: zombies or creative destruction

22-12-2015 | 四半期アウトルック

Credit growth in China and Quantitative Easing (QE) in the US, Europe and Japan were medicines that worked for a while. Cheap money kept zombie businesses afloat and prevented creative destruction. However, the commodity cycle has rolled over and the credit cycle is proceeding. Funding pressure is increasing, the US credit market is full of animal spirits and volatility is back.

  • Victor  Verberk
    Victor
    Verberk
    Deputy Head of Investments

Speed read

  • Continued monetary stimulus is preventing creative destruction 
  • Zombie companies have been kept alive with free money 
  • The credit cycle is turning, it points to pain and opportunities ahead

Credit valuations have adjusted compared with other developed asset classes. We still advise some patience and preach to remain up in quality. A much worse situation (pure fear, panic and loathing) is still probable. That said, our flexible investment style already allows us to find attractive opportunities in the global credit markets. Parts of the market have repriced already. 

We remain constructive on Europe versus the US driven by a much better technical. On the margin we believe Draghi is right and the Fed is wrong on the economic outlook. We acknowledge though that some economies are at difficult to understand crossroads. With respect to emerging markets, we are entering a second year of caution, but will be more open to opportunities.

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“Emerging markets hanging by a thread”

In 2008 the debt super cycle burst. A 20-year period of overconsumption, private sector releveraging and central banks being too accommodative came to an end.  In hindsight also the commodity bubble peaked just before 2008, with a high in, for example, inflation-adjusted oil prices. To make things worse the world entered into a series of banking crises as a result. It was triple witching hour.  

We have written enough about the lessons we should learn and the mistakes that were made. The central banks however chose the same medicine that caused the crises; more monetary accommodation. To a certain extent measures like LTROs, TARP and QE did help to prevent an outright depression. A new problem emerged though. As the world’s central bank (Federal Reserve) started printing money, it indirectly caused enormous monetary easing in emerging markets. That in combination with in generally populist governments that were more focused on enjoying the party than reforming the economy (Brazil), caused a spending boom and misallocation of capital in emerging markets. The result was an identical debt super cycle, funded with USD debt in the private sector. 

Emerging markets are hanging by a thread. It probably is the next stage of the aftermath of the debt super cycle. China is facing serious reform pain with the Producer Price Index (PPI) at a negative 6% for years now. Profitability is suffering at state-owned enterprises (SOEs) and debt growth has been too high. Non-performing loans at banks are rising fast. When one looks at the real numbers corrected for backdoor sales of non-performing loans to asset management companies, taking a Western way of defining non-performing loans, things do not look nice. Do not count on fiscal stimulus since the total fiscal deficit (local government plus central government) is approaching 10%.  Capital flight is huge and something needs to be done. Foreign exchange reserves are melting fast. The CNH is bound to depreciate further causing pain in satellite emerging countries in Asia. 

Of course it is not all doom and gloom. The Latin American bond markets reflect the political and economic misery these countries are facing. For a research and value driven credit team this offers opportunities. More opportunities like this may develop in 2016. 

Debt super cycle and credit cycles

We have had long debates about the debt super cycle, the credit cycle and even commodity cycles. At a certain moment there are too many cycles at the same time! Nevertheless we think we understand how all these cycles play out. A few lines on these three cycles help: 

  • The debt super cycle lasted for more than two decades until 2008. It will probably take many more years of lower growth and inflation than people might expect to digest this debt. In that sense economic theory does not hold anymore. Too many private individuals, corporates and governments have a debt trauma. Including the recent emerging market debt cycle, global markets need a lot of time to digest this debt pile. That is the reason why economic growth forecasts have been consistently too high in recent years.
  • The credit cycle is more relevant for our own short-term planning and impacts the portfolios directly. We believe we are in a really late-cyclical stage. Animal spirits in the US are very much a concern. To a certain extent these have been priced in but until we see fear and panic, we stay close to a beta of 1 and up in quality. Especially the US, Brazil, energy and metal sector bond markets are pricing in a lot of negative news already.
  • Finally, there is a commodity cycle that rolled over. This cycle explains nicely why a debt super cycle is so painful when it bursts. When asset prices rise, and inventories (or whole business cases) are developed partly with debt it is all fine until prices stop rising. When prices drop, negative equity emerges which needs to be fixed with risk bearing capital; equity raisings or debt restructurings. Expect much more cuts in dividends too.


There is also a note to be made about unintended consequences of all this money creation and zero interest rates policies around the world. It increases imbalances in the sense that it is a continued tax on household wealth (creating inflation, lower saving proceeds), causing low median real income growth and sticky and high unemployment. The flip side is that corporates are making record margins and corporate profitability as a percentage of GDP is high. QE also pushes for asset price inflation. This means that inequality among the population in terms of wealth increases. All this is a tax on consumption. Another consequence is that whole business models like insurance companies or pension funds are not properly functioning. The incentive to save is disappearing, a key role in a capitalist society. 

The role that cheap money plays therefore keeps many companies running that would normally have defaulted. On the ruins of a default cycle, new companies emerge. This process of creative destruction might seem theoretical but practice is that CCC companies or Greece, for example, do not default when yields are so low for such a long time; zombie companies have been created. The same phenomenon we see in China and formerly in Japan, where unprofitable companies get their debt rolled over but basically should default. This might change now with the commodity cycle breaking and liquidity tightening in the US. Bank lending surveys in the US point to a net tightening now. We truly believe the credit market and credit spreads are telling something. Volatility is on the rise. 

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加入協会: 一般社団法人 日本投資顧問業協会

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