This blog is an extract from the July 2018 TopFund Guide.
It is no secret that poor quality debt creates the fragility which triggers nasty crashes. A 2016 study of 17 economies over 150 years highlighted that high levels of debt have been associated with the “more spectacular crashes”.
Hyman Minsky identified this back in 1974, based on ideas which were then already more than a century old. The pivotal point is called a “Minsky Moment”. As John Mauldin tells us “such moments arise when a long period of stability and complacency eventually leads to a build-up of excess debt… At some point the branch breaks, and gravity takes over. It can happen quickly too.”
It now appears that important lessons were not learnt. In 2008 total debt (of governments, companies, and households) was about 200% of the size of global economy (GDP). It is now in excess of 240% - notably and worryingly higher.
Debt can be very useful - enabling a company to invest in new equipment or enabling someone to buy a house. But when it gets to a certain level it no longer adds value - it just increases danger:
- Too much debt slows down economies.
- Too much debt encourages speculation.
- Too much debt is associated with spectacular market and economic crashes.
A prolonged period of low interest rates has the benefit of allowing the economic cycle to go on longer. On the other hand, it encourages complacency and speculation, storing up trouble for later.
Speculation encourages more debt, and lower quality debt, and evidence of this is a strong indicator that the economic and stock market cycle is very long in the tooth. The current evidence is stark.
One old hand, David Rubenstein, said “it is easier to raise money than at any time I’ve been in the business over the last 30 years or so” - complacency indeed.
In the last edition of TopFunds there was a section entitled “High Yield Bonds: junk returns?
” Our focus was on European high yield bonds where there was vivid evidence of a mania. For example, the yield on high yield bonds issued by wobbly European companies was the same as for US government bonds – that is crazy.
Many of these companies, in Europe or elsewhere, are inherently marginal, and are very much at risk even with a mild economic downturn. John Mauldin and Grant Williams* recently reviewed one company which issued such bonds, WeWork.
WeWork rent small spaces in large offices to the herds of freelancers and contractors which roam the “gig economy” – that part dominated by freelancers and those on short term contracts. It has the merit of being a clear business model which certainly meets a need.
But what happens when we get an economic slowdown? (which we will, even if those under age 30 might be forgiven for thinking that the economic cycle has been abolished).
According to property expert John McNellis, WeWork “neither signs nor guarantees its own leases”. For each lease it creates a separate company with limited capital.
Result? When the young people inhabiting the WeWork “spaces” find that even these rents are too great, it is the property companies that will carry the can, not WeWork.
Then the dominoes begin to tumble.
Most property companies have their own debts, and this makes them less easy to service. The risk then gets passed along to the bank from whom they borrowed. The bank in turn reacts to the problem coming down the pipe, and begins to pull in its horns, being prepared to lend less even to credit worthy customers.
It’s called a credit crunch. Those over age 30 will remember the last one, just 10 years ago.
These early-stage, but fast growing, companies often sell a dream. It is the ongoing laboratory experiment, as Grant Williams calls the central bank measures long past being needed, which has enabled a good number of big names to emerge from the wreckage of 2008/9 and to sell their dream to investors. He identifies Uber, AirBnB, Snapchat, and Tesla.
WeWork simply illustrates what has been going on more broadly, and how it will impact the wider economy. There will be others in a much worse position.
In Part 2 we broaden out the analysis and also consider the really horrible problem – liquidity.