"We have seen a return of practices that made people nervous in 2007," says Russ Kowsterich, chief investment strategist at BlackRock, "There are no bargains in fixed income." This quote is from the outlook for the credit market for 2014 as presented by Tracy Alloway and Michael Mackenzie in the Financial Times.
As we all know, the Federal Reserve has pumped billions of dollars into the credit markets in an effort to keep the commercial banks open and spur the economy. As a consequence there is cash all over the place. One of my concerns for 2014 is how is this cash going to be used.
I have tried to give some hint as to the use of these funds: first, in terms of helping to keep the commercial banking system going; and second, holding onto cash, paying dividends, and buying back stock.
These funds are certainly not going into increasing economic output. The economist John Taylor remarks, "business firms continue to be reluctant to invest and hire, and the ratio of investment to GDP is still below normal."
The problem seems to be that all the money being pumped into the economic system is primarily staying within the "financial circuit" of the economy and very little is entering the "real circuit" of the economy. As a consequence, things are happening on the financial side with very little spill over to the production side.
This is not unlike what happened in the 1990s and in the 2000s. The behavior built up in the 1960s, 1970s, and 1980s, as people came to expect first price inflation…and then credit inflation.
In the earlier years, the creation of credit had a greater impact on the production of goods and services and so policy makers got a real bounce in the economy by government deficits and monetary expansion. Over the past twenty years as people got accustomed to the continued injections of the federal government, expectations changed. They could play games just in the financial side of the economy and not have to get involved to any degree the messy exercise of producing goods and services.
Credit inflation and financial innovation became the major game in the economy. Just look at proportion of people who worked in the financial sector in the early 1960s and the proportion of people who worked in this sector in the early 2000s. And, General Electric (GE) and General Motors (GM) were getting more than fifty percent of their profits from their financial subsidiaries!
Once again we are getting behavior in the financial markets that was observed in the 1990s and 2000s. Just listen to a speech that was given last February by Jeremy Stein, a member of the Federal Reserve's Board of Governors," A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to 'reach for yield.'"
I have noted constantly over the past five years what happens in a period of credit inflation. First, people stretch to take on more risk in their portfolios; second, people employ more financial leverage; third, people finance long-term financial instruments with short-term debt; and fourth, people create more and more financial innovations.
Stein was concerned about a return to this behavior in early 2013. As the Financial Times article reports, "Since then those warning signals have flashed even brighter."
I cannot reproduce in this post all of the charts that are included in the Financial Times article. I think that readers of this post should take some time to look at what is produced in the Financial Times article. The information is sobering.
For example, the issuance of "triple C" rated bonds, the lowest possible designation, totaled $15.3 billion through June in 2013. Over the past ten years, the previous high is $11.3 billion in 2012. And, before that, only $10.6 billion of these CCC-rated bonds were issued in 2007, the previous high.
Collateralized loan obligations through November 2013 were at $75.9 billion, not too far below the peak level these issues reached in 2006 and 2007. "Covenant-lite" bonds "accounted for almost 60 percent of loans sold in 2013 compared with a 25 percent share in 2007…a total of almost $60 billion." "Payment in kind" bonds…where borrowers have an option to repay lenders with more debt…were getting close to the 2008 total just through May 2013. Commercial mortgage-backed securities, although running far below the totals of 2005 through 2007, have now exceeded in 2013 the totals reached in 2004.
And, there almost seems to be a shortage of securities available to investors since the Federal Reserve has taken so many bonds off the market. The Financial Times cites Citigroup research that estimates the "net" issuance of financial assets in 2013 to be about $1 trillion which is far fewer than the $3 trillion to $4 trillion sold in the years before the financial crisis.
As a consequence, the prospect is that more and more securitization will take place in 2014 and beyond.
The conclusion I draw from this at the beginning of 2014 is that a lot is going on in the financial sector of the United States economy, but not a whole lot of this action is going to be transferred to the production of goods and services.
Corporate bond sales set a record for 2013 according to the Wall Street Journal. In the United States, merger activity in 2013 got back to the trillion-dollar level according to the New York Times. (More on this activity in an upcoming post.) But, issuance of bonds and acquiring companies does not add…at least initially…to real economic activity and growth.
The problem is…as analysts have mentioned…that the market has been…and is still being…distorted by the monetary policy of the Federal Reserve. How this will work out in 2014 is the big question. I have written about this elsewhere…"the biggest market risk for 2014 is the Fed getting it wrong." The scary part about this unfolding is that in terms of the renewal of credit instruments that played a part of the 2000s, it seems to be déjà vu all over again.
As for the stock market in 2014…I will write about my views on this very soon.