Equity and bond investors, despite the troubling economic backdrop imposed by COVID-19 lockdowns, are enjoying trillions of dollars of central bank buying of government bonds, mortgages, individual corporate bonds and exchange-traded funds. US equity markets have surged 40 per cent though the economy is forecast to decline at an annualized rate of 35 per cent this quarter. Emergency economic measures enacted during the financial crisis have been ratcheted up in response to the COVID-19 crisis. Broad-based monetary policy measures, designed to maintain corporate access to capital, ensure corporate America will survive a prolonged shutdown.
Washington’s policies carry both intended and unintended consequences. Thanks to the government backstop, borrowing has ballooned while earnings have plunged. S&P profits ex-financials are expected to plunge 42 per cent year over year through Q2/20. At the same time, corporate debt issuance could approach $1 trillion this year, according to Bloomberg estimates. So far this year, cruise lines have borrowed $8 billion and airlines have borrowed $14 billion.
The unintended impact of Washington’s protective policies, which have remained in place for more than a decade, is that they have prevented bankruptcies, a cathartic process that enables stronger startups to replace tired and out-of-step businesses. Nearly 4,000 business filed for Chapter 11 bankruptcy during the depth of the financial crisis recession in 2009. Since then, and consistent with the Fed’s balance sheet expansion, bankruptcy filings have steadily declined, paving the way for a growing population of “zombie” companies whose businesses who don’t earn enough in profit to cover their debt service payments. These zombies must continually borrow to survive. It is estimated that zombies comprise 10-15 per cent of the global corporate sector. According to a recent CNBC report, heavily indebted zombie companies control nearly 2.2 million US jobs at a time when the country is saddled with an employment crisis.
Carrying a corporate population of zombies comes at an economic cost. Unprofitable enterprises occupy space that could otherwise be devoted to healthy companies. Zombie companies are not productive because they can’t afford the capital expenditures required to keep pace with their industries. Moreover, zombies compete with healthy companies for scarce resources, like labor, office space and capital. Unprofitable selling and distribution tend to depress profit margins for everyone by creating a surplus supply of goods and services that keeps a lid on selling prices. Consider Sears and Kmart, two high-profile zombies controlled by Sears Holdings. The organization has not earned an annual profit since 2011. Yet the sclerotic retailer employs 89,000 workers and occupies 275 retail stores selling an outsized supply of uncompetitive goods. While on the surface employing more people sounds like a good idea, unhealthy companies divert labor resources away from more productive competitors. An excess of zombies tends to depress growth, productivity, interest rates and inflation – an affliction the US has been saddled with for most of the recent decade.
Japan offers a valuable case study on the intended, and unintended, consequences of monetary largesse. Zero interest rates have been the norm in Japan since the 1990s. The country that invented quantitative easing has plumbed depths of monetary policy most central banks have dared not attempt, such as purchasing equities. Japan’s experience exposed many of the economic side effects of awarding “participation ribbons” to every company, profitable or not. Japan has suffered decades of lackluster business investment, paltry productivity, tepid inflation and interest rates spiraling lower – all consequences of keeping their economy on life support for too long.
At ever-decreasing lending costs, quantitative easing is keeping a growing share of US companies on economic life support, too. Bad companies are propped up and can’t be supplanted by more robust startups. Eventually, imposing nanny-state policies for too long damages the vibrancy of the economy, leading to a misallocation of capital, lower capital investment, diminished productivity and declining potential economic growth. In 1979, business investments in plant, property & equipment, structures and software represented 20 per cent of US economic activity. Since then, it peaked at 19 per cent in both 2000 and 2006 and has been in steady decline. Productivity growth – the ability to expand output with the same effort – has charted a similar path.
The pandemic and its aftermath will only increase the need for creative destruction, as the economic landscape will be permanently altered. Returning to monetary “normalcy” by reducing the Fed’s balance sheet and raising overnight interest rates would trigger an economic cleansing, replacing sick and unprofitable companies with younger, more energetic upstarts. Doing so, however, would prompt an economic plunge and a substantial rise in unemployment in the near term. Eventually, attractive yields would lure courageous capital back into the financial system and a heathy recovery could ensue. The world got a couple of bitter tastes of Federal Reserve normalization attempts, however, and didn’t like them. The first was in May 2013, when Fed Chairman Ben Bernanke famously triggered what is commonly called the “taper tantrum” when he tipped the Fed’s intentions to reduce its bond-buying program during an appearance before Congress. Liquidity-reliant emerging markets responded by abruptly plunging 15 per cent. The second brush with normalization occurred in 2018 when the Powell Fed attempted to hike the overnight interest rate from 1.5 per cent to 2.5 per cent. The move was greeted with a 30 per cent retreat in US small caps. In both instances, monetary policymakers quickly backtracked and have not contemplated returning to normal since then. Fed Chairman Jay Powell summed up the Fed’s stance by asserting, “We’re not even thinking about thinking about raising rates,” at a press conference a couple of weeks ago.
Unfortunately, there is strong political pressure to keep the monetary spigot wide open. No one in Washington has the stomach to oversee an economic purge on their watch. For that reason, recent trends will continue. Besides, Twitter is a powerful weapon against Fed independence. The tradeoff is short-term politics against longer-term productivity. Economic theory suggests that holding interest rates too low for too long results in inflation, but thanks to a growing population of zombies, easy money is delivering just the opposite.
Eventually, we must prepare for a Volcker moment, when the Federal Reserve inflicts short-term pain to correct long-term imbalances. Clearing the decks of zombies will lead to widespread bankruptcies, massive layoffs, a stock market plunge and economic retrenchment. Between 1975 and 1980, when Paul Volcker’s Fed ratcheted overnight rates from 4.75 per cent to 20 per cent to break the back of inflation, unemployment spiked from 5.6 per cent to 7.8 per cent and the economy slid into recession. The political pressure on the towering 6’ 7” Fed chairman was intense, but he refused to bend. The move proved cathartic, setting the stage for a forty-year economic tailwind for the stock market and risk taking. Let’s hope we can do it again.