Why You Need To Prepare For All Hell To Break Loose

August 16, 2017

Why You Need To Prepare For All Hell To Break Loose

  • The last stock bull market was influenced by central bank activity, that’s clear. What’s next is the question.
  • I’ll describe three potential scenarios that could impact our financial system.
  • One is good, the second is interesting, while the third is ugly.

Introduction

The general expectation is that the FED will start selling securities in order to tighten monetary policy, that the ECB will slowly stop buying, and that nothing will change in Japan. Nevertheless, such a situation would lead to an environment where the additional liquidity created by central banks finally dries up. As the liquidity provided by central banks is the main reason behind this bull market, should investors begin to cut their positions?

In order to elaborate on this question, we’ll first analyze the situation, the expected situation, and then possible scenarios in order to give you the best answer on how to prepare yourself for what might happen. It’s extremely important to do so and, as you will see, it isn’t that difficult.


The Current Situation 

Not many mention it, but there is one, and only one, reason why stocks have gone up in the last 8 years. Stocks have gone up because central banks bought assets on financial markets in order to stimulate the economy. Whatever you buy on financial markets, it’s immediately reflected on other assets as global money flow is extremely fast.


Figure 1: Central bank purchases since 2009. Source: CE Capital.

If you don’t believe that to be the case, just take a look at the correlation between the FED’s balance sheet and the S&P 500.


Figure 2: The correlation of the S&P 500 and central bank activity is almost perfect. Source: FRED.

The lower correlation in the last year and a half, where the S&P grew significantly, is thanks to the continuous ECB and BOJ purchases (see Figure 1).

The Expectation

Now, by taking a look at figure 1 again, we can see that the general rhetoric in the U.S. and Europe has been to start lowering monetary stimulus. This will lead to a situation where there is no more liquidity injected into the system.

Accounting for the FED’s trimming and BOJ continuous purchasing, central bank activity should even out from 2018 onward.

Now, what many fail to recognize is that the above is just expectation. This means that anything can happen and let’s look at a few scenarios.

Scenario #1 – Situation Develops As Expected

If the situation develops as expected, what will probably happen is that asset prices won’t be significantly impacted as only global central bank balance sheet trimming would severely impact stock market valuations. The financial environment we are living in now is one where most are addicted to low interest rates and a significant change in interest rates would quickly lead the global economy into a recession even worse than the recession in 2009.

If we take a look at the high yield (junk) effective yield, we can see that it’s at historical lows.


Figure 3: BoA Merrill Lynch US High Yield Effective Yield. Source: FRED.

Now if that yield increases, we quickly get a situation similar to 2009 where all the companies that borrowed too much—that is why they have a junk credit rating—suddenly find themselves in financial distress.

For example, Tesla (NASDAQ: TSLA) recently announced a $1.8 billion offering and expects an interest rate of around 5%.


Figure 4: Tesla’s interest rate expectations. Source: Bloomberg.

With an interest rate of 5% on $1.8 billion, Tesla’s yearly cost would be around $90 million. If interest rates surge, especially on high yields, the refinancing suddenly becomes more difficult and the $90 million can quickly turn into $180 million which would be a significant blow to companies like Tesla that don’t have the cash to cover higher interest costs.

Tesla is just one of the many examples but one of the main reasons why central banks will have to do whatever it takes to keep interest rates low. Especially when you think about how more than 30% of the U.S. corporate debt market is high yield, this is junk. Which leads us to scenario number two.

Scenario #2 – Increased Central Bank Monetary Stimulation

Last week there was a significant amount of news regarding North Korea. I don’t want to comment on what could happen there as nobody can understand what goes on in the heads of crazy politicians. But, what I can do is show how at the first sign of any kind of financial turmoil, interest rates jump up, especially for junk bonds.


Figure 5: Spike in junk bond yields thanks to North Korea fears. Source: FRED.

The spike in high yields might seem meaningless, but what’s important to note is how abruptly it can change and the refinancing environment for many companies with a junk credit rating can suddenly completely change. As we’re talking about more than 30% of corporate debt, the impact on the economy would be disastrous.

Therefore, the second scenario in front of us would see central banks increasing stimulus at any sign of trouble, thus keeping interest rates low and delaying the announced trimming. This would bring the financial environment to where it was a year and a half ago and I find that the most probable scenario for the short and medium term.

Scenario #3 – Inflation

The third scenario is a situation where central banks lose control and we finally see inflation. This would disable further stimulus or lead to hyperinflation. In either case, the outcome would be disastrous for the economy and the painful deleveraging part of the economic cycle would be inevitable. As we have enjoyed 75 years of an increasing debt cycle, it would take many years, perhaps even a decade, to properly deleverage. The despair would probably lead to more turmoil and all hell could break loose.


Figure 6: U.S. public debt (red) and U.S. public debt in relation to GDP (blue) since 1967. Source: FRED.

As in the last 50 years the debt to GDP ratio has been going up constantly, and increasingly more quickly in the last 8 years, it’s practically impossible to revert this without painful long term measures. This is the scenario I am least hopeful for as I’m not concerned much about economic repercussions as much I’m concerned for social and political issues that might arise when you take the power of leverage from the people.

Conclusion

I’ve described three possible scenarios that might affect the global financial system.

Nobody can know which scenario and when it will prevail as there are too many, still unknown factors influencing such outcomes. Therefore, from an investing perspective, the best thing to do is to be prepared for anything.

Keep reading Investiv Daily as we’re always discussing interesting investing ideas that also provide hedges to any kind of economic environment.