Outsized Debt Fuels The Perfect Market Storm

by: Douglas Adams


While many economists and analysts alike agree that the current level of US growth is unsustainable, investors dumped shares during the month with surprising abandon.

Corporate investment slowed dramatically in the 3rd quarter from outsized levels in the 1st and 2nd quarters while inventory spending swelled.

Private and public sector debt levels remain elevated across the globe as central banks continue to remove monetary accommodation while pushing borrowing costs ever higher.

October's harbinger was likely overplayed but still presents a viable dress rehearsal for lower growth levels to come.

The last several weeks of October have seen markets worldwide fall with startling unison. After reaching its YTD peak of 2,929.67 on the 21st of September, the S&P 500 has fallen to the cusp of correction territory, falling 9.84% through Monday’s market close (29 Oct). The benchmark (green-red bars upper frame) is now well below its 20-day exponential trading average (blue line, upper frame). The tech-heavy Nasdaq (green bars, lower frame) sketched out its YTD high on the 29th of August at 8,109.69, fell 11.62% over the same period. In the course of five short weeks, US markets have gone from knocking on the door of all-time highs to the gates of correction territory. The Nasdaq has also fallen below its 20-day exponential trading average (blue line, lower frame) over the period. Collectively, October has delivered the worst monthly performance since 2012 (see Figure 1, below).

Figure 1: S&P 500 Index and the Nasdaq Composite


Internationally, this market malaise has been much more pronounced and enduring. The Nikkei 225 peaked on the 2nd of October YTD at 24,270.62, dropping to 21,184.60 through Friday’s market close, down 12.72%. Hong Kong’s Hang Seng Index peaked for the year on the 26th of January and has fallen steadily throughout the course of the year, currently deep in bear territory at 25% from its January high. The mainland’s Shanghai Composite has sketched out a similar path, down from its January high by 27%. In Europe, Germany’s DAX Index wallows deep in correction territory, down 17% through Friday’s market close. The STOXX Europe 600 Index is down just over 12% from its January YTD post. Casual investors, analysts and economists alike, are assigned the unenviable task of answering the simple question of why. Unfortunately, there is not one but myriad responses to the current market malaise confronting a bull market--now 10-years old and quite possibly long in the tooth. That said, the recurring theme of debt in the financial system heads the proverbial explanatory lists.

Most economists do expect a deceleration in US economic growth as the fiscal stimulus impact from last year’s tax cuts washes out of YOY comparisons. For its part, the Federal Reserve projects US GDP growth for the year at 3.1%, falling to 2.5% in 2019, 2.0% in 2020 and 1.8% in 2021 and beyond. Business tax cuts are meant to increase investment in software, plants and equipment, boosting the economy’s growth rate now and its potential growth far into the future. The White House’s projection of sustained 3% growth hinges on a business investment boom. Yet since the stellar posts of 8% and 6.4% in the 1st and 2nd quarters, respectively, corporate investment has since fallen off sharply, contracting 0.3% annualized in the 3rd quarter. Ditto for factory and structural building which contracted 7.9% during the quarter after surging 13.9 and 14.5% annualized in the 1st and 2nd quarters. Equipment purchases peaked in the 4th quarter at 9.9% annually as oil and gas E&P companies expanded their operations in the US oil patch. Corporate spending has since trailed off, falling to 0.4% annualized through the end of the 3rd quarter. In fact, corporate spending in the first estimate of 3rd quarter appears to have been focused almost exclusively on inventory buildup. While the holiday season certainly looms, circumventing supply chain disruptions stemming from Trump administration’s online tariff regimes appear to be growing. Meanwhile, US exports contracted 7% on an annualized basis for the quarter, the largest drop since the 1st quarter 2015, as the US trade deficit widened by $76 billion in September.

Figure 1: German, US and Japanese 10-year Notes YTD


Broad measures of financial conditions look toward long-term interest rates, borrowing costs, Forex fluctuations and share prices to determine overall market direction. Higher borrowing costs weigh heavily on debt-financed economic growth, not to mention the service on existing debt. Outstanding credit to nonfinancial sectors at market value as a percentage of GDP is 271.2% of total output in advanced countries through the end of the 1st quarter with the US posting 250% of GDP for the period. The advance is just over 9% higher than at the beginning of the Great Recession of 2007. In the emerging market space, outstanding credit stands at 198% of total output. In the euro area, that total comes to 260% over the same period, with Germany at the low end of the range at 174% and France (not Greece or Italy!) occupying the upper reaches of the spectrum at 302.8% of total output. In Asia, Hong Kong tips the scales at 376.1% of GDP, followed closely by Japan at 368.1% over the same period. China weighs in at 261.2% of total output. The yields of 10-year sovereign debt in Germany (blue line), Japan (orange line) and the US (green bars) sold off sharply in the beginning trading days of September, pushing all three issues to YTD highs for the year.

The yield on the 10-year Treasury pushed through the psychologically important 3% barrier in the second week of September to its YTD high of 3.26% in the first week of October before coming face-to-face with a sudden and broadly-based weakness in US equities. The encounter sent bond prices sharply to the upside as investors reversed course and quickly reached for the traditional safe harbor vehicles to weather the storm. The 10-year Treasury yield has retrenched with equal aplomb, falling almost 20 b/p since its mid-September peak. Investor expectations of a 4th uptick in the federal funds rate have fallen off from a probability of just north of 80% in the last week in September to 69% through today’s market close. Cash has become much more competitive of late as markets blow through the threshold of correction territory for the second time this year.

The $1.6 trillion market for leveraged loans in the high-yield space that are then packaged into securities and sold to investors worldwide has long caught the public angst of central bankers both in the US and abroad. Last week, Janet Yellen lent her voice to a growing international chorus, warning of a growing systemic risk stemming from the brisk marketing of such loans, echoing the concerns already voiced by the Bank of International Settlements and the central banks of Australia and the UK. Investors are attracted to leveraged loans by their floating rates which offer a modicum of protection from rising interest rates from the Federal Reserve as well as their seniority over unsecured bonds—despite the hollowing out of investor protection from default. Leverage loans have returned about 4% YTD, which appears to satisfy bond investor’s insatiable appetite for yield in a low-yield environment. First lien recovery rates continue to shrink, currently averaging 66-cents on the dollar, down from an historical average of 77-cents. Second lien loan recovery rates fall even further to just 14-cents on the dollar from 43-cents historically.

US nonfinancial debt exceeds $14.8 trillion through the end of the 2nd quarter 2018. Bond debt accounts for about 43% of outstanding leverage with an average maturity of roughly 15 years. For smaller and mid-sized companies unable to tap the capital markets, the average maturity of outstanding business loans comes to just over 2 years. The realization has pummeled both the Russell 2000 and the S&P 400 indices which both are in negative territory for the year, a complete turnaround by investors since the Trump election in November of 2016. These particulars imply roughly $4 trillions of loan repayment per year. Through the end of the 1st quarter, total credit to the US nonfinancial sector amounted to 150.9% of total GDP.

Meanwhile, the Treasury expects to issue more than $1 trillion in debt through the end of the year as the combination of higher government spending and lower tax revenues push the country’s current account deficit ever higher. With projections of issuing $425 billion in Treasuries bills and notes in the 4th quarter, the total for the year comes to a cool $1.34 trillion. That compares with $546 billion in US debt issues through the end of 2017. It will be the highest issuance of debt since 2010 during the heat of the Great Recession. The downside of rising deficits is not only the restraint on economic growth from competition between private and government sectors for available funding from capital markets. Equity trading becomes all the more volatile.

Still, October’s equity sell-off appears to have gone well beyond underlying fundamentals. The latest results from 3rd quarter earnings reports to date project earnings up around 23% YOY which is one of the highest rates of growth of the past seven years. Aware of the pending falloff in projected economic growth as the year wears on, investors appear all the more focused on forward guidance which has widely been viewed as largely problematic to date. The ambivalence has curiously added sturm und drang to the equity sell-off during the month, wiping off almost $3 trillion in market capitalization from the Nasdaq Composite and just over $2 trillion from the S&P 500 benchmark, according to estimates. The S&P 500 is down just over 9% from its YTD high posted on 20 September while the Nasdaq Composite is in correction territory, down 12.21% from its YTD high posted on 30 August.

Figure 3: Amazon, Netflix, Boeing and Caterpillar against the S&P 500


Amazon (AMZN) (green line) racked up $56.6 billion in total sales through the end of the company’s fiscal 3rd quarter, up just over 29% YOY. North American sales, which comprised 61% of total revenue, increased 35% for the period. International sales rose 13% while Amazon Web Services rose 46% YOY to $6.7 billion. Operating income for the period came to $3.7 billion, an increase of 973% YOY. AWS was responsible for just over 56% of the company’s operating income for the period. The company’s forward guidance for the 4th quarter was more modest with expected sales in a range of $66.5 billion to $72.5 billion which computes to a growth range of between 10% and 20% on total quarterly sales. Operating income is projected on the light side at between $2.1 billion and $3.6 billion, given the levels achieved in the 3rd quarter. JEDI is the Pentagon’s giant cloud project in which Amazon is considered the frontrunner in the competition that will be awarded by the end of the year. The contract is worth $10 billion over the decade. Since the first trading day of October, the company is down 24%.

Netflix (NFLX) (orange line) also put up a banner 3rd quarter. Total revenues hit $3.99 billion through the end of the period which was up from $2.98 billion YOY, an increase of 34%. Operating income soared 130% to $480.67 million while net income hit $402.84 million, up 211% YOY. Paid subscriptions to the company’s streaming services worldwide broke through the 130 million threshold during the quarter, a 25% increase YOY. Another 8 million paid subscriptions are anticipated through the end of the 4th quarter, a 6% QOQ increase. Revenues are expected to increase to $4.19 billion, up about 5%. Free cash flow in the 4th quarter is expected to be close to a negative $1.7 billion which adds to the $18.6 billion in debt obligations through the end of the 3rd quarter. The company is down just over 25% for the month of October.

Boeing (BA) (black dotted line) net earnings soared 31% through the end of the 3rd quarter to $2.4 billion. EPS jumped 36% during the quarter to $4.07/share while dividends rose 20%. Meanwhile, the company’s effective tax rate went from 29.9% in the 3rd quarter 2017 to -10.8% for the three months ending September 2018. The company’s work backlog through the end of the 3rd quarter was $491.18 billion of which 84% of the total comes from the company’s commercial aircraft sector. Another $57.88 billion or 12% comes from defense work while the remaining 4% of the company’s backorder book comes from global service contracts. About 24% of the company’s total backorder book will be converted to revenue through 2019 and about 69% will be converted to revenue by the end of 2022. The company is down almost 9% for the month of October, prior to the crash of the company’s 737 Max off the coast of Jakarta.

Caterpillar (CAT) (purple line) 3rd quarter revenues came to $13.5 billion, up 18% YOY. Earnings per share came to $2.88/share, up 63% YOY while consolidated operating profits soared 41%, also YOY. The company’s effective tax rate fell to 24% from 32% YOY. Caterpillar logged double digit YOY growth across all of its segments with its two largest segments (88% of total revenue) both posting 16% and 15% increases, respectively. Caterpillar’s forward outlook through the end of the year sees earnings in the range of $10.65 to $11.65/share, which includes a net estimated tax benefit of about $95 million booked in the 3rd quarter. The company’s backlog book through the end of the 3rd quarter stood at $17.3 billion. Through the month of October, Caterpillar has fallen 23%.

Real personal income increased 0.2% in September with consumer disposable income and spending increasing 0.2% and 0.4%, respectively. Imports soared during the month to $217 billion, signaling consumer spending is very much alive and well. Somewhat surprisingly, consumer confidence soared to a reading of 137.9 in October for the measure's highest reading since September 2000, despite the month’s market swoon. Stocks do tend to be owned by wealthier Americans. Lower income consumers with fewer shares hold the availability of jobs and the unemployment rate, currently at its lowest level since April 1969, in higher economic esteem. This signals a fairly resounding thumb’s up to further economic growth. Wealthier Americans would likely demur. Inflation remains all but dormant with headline PCE inflation keeping consumer purchasing power firmly intact. The measure advanced a scant 0.1% through the end of September and 2% YOY. Core PCE posted a gain of 0.2% for the month and 2% YOY.

The tailwind of share buybacks will begin again next month, adding volume to equity markets for the balance of the year now that share prices are significantly cheaper than at their peaks in mid-September. Market nerves should summarily calm.

Disclosure: I am/we are long AMZN, NFLX, BA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.