TREY REIK | Everything is Cool

By Trey Reik, Senior Portfolio Manager, Sprott Asset Management USA, Inc.

On Nov. 14, Fed Chair Jerome Powell and Dallas Fed President Robert Kaplan conducted an onstage question and answer session at the Dallas Fed. Responding to President Kaplan’s questions, Chair Powell’s cool-and-collected delivery made U.S. monetary policy seem like an absolute snap. The upbeat message from the Dallas stage was best summed by Mr. Powell’s observation that “Fed policy is part of the reason the economy is in such a good place right now.” However, because U.S. financial markets have remained noticeably rattled ever since Mr. Powell’s seemingly innocuous “long way from neutral” comment on Oct. 3, 2018, we find it constructive to parse cautious nuggets in Chair Powell’s copacetic narratives.

Along these lines, Chair Powell seemed to imply from the Dallas stage a subtle downshift in telegraphed Federal Open Market Committee (FOMC) tightening in stating “we have to be thinking about how much further to raise rates and the pace at which we will raise rates.” After referencing potential headwinds of slowing growth abroad, fading fiscal stimulus and lagged effects of eight Fed hikes, Chair Powell eventually narrowed in on one specific area of growing Fed concern: excessive corporate leverage. In Mr. Powell’s soft-spoken words, “There is some significant corporate borrowing and we have our eyes on that.” Having subsequently refreshed our focus on U.S. corporate debt levels, we can only characterize Chair Powell’s matter-of-fact depiction as dramatic understatement.

Corporate Leverage Locomotive

We have suggested that improving U.S. bank balance sheets foster false investor confidence that the excessive leverage at the root of the financial crisis has been repaired. In reality, as the Fed has dedicated eight years and trillions of dollars to nursing systemically important banks back to health, QE (quantitative easing) and ZIRP (zero interest rate policy) have progressively compromised the financial strength of the U.S. corporate sector. Not only have share buybacks imperiled countless balance sheets in the name of ephemeral EPS (earnings per share) gains, but the bulk of U.S. corporate governance has eroded into a culture of undisciplined borrowing and zombie credits.

Low rates and high share prices have distracted investors from the post-crisis explosion in corporate leverage. The total U.S. corporate bond market has almost tripled from $2.4 trillion in December 2006 to $6.7 trillion today. The junk portion of that total represents a startling $1.2 trillion. As the purview of hedge funds and aggressive investors, the junk market is essentially cordoned off from the far more relevant $5.4 trillion investment grade market, in which the vast majority of institutions are restricted by charter to focus their investments. After years of relaxed financial conditions, however, almost half the investment grade universe is now composed of bonds rated Triple-B, the lowest investment-grade category (up from one-third in 2006). This means that roughly $2.6 trillion of investment grade debt hovers just one category above junk status. Further, as rating agencies have factored in declining debt-service in a ZIRP world, the average ratio of total debt-to-EBITDA in the BBB universe has soared from 2.0x in December 2006 to 3.3x today.

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