Financial Nagasaki — Interest Rates, Overvaluation,The Corporate Debt Crisis and Why We Might Be On The Brink of the next financial crisis
By: Keeno Ruark Koopman
Tags: Trading, Business, Finance, Macroeconomics, Investing

I wrote this report in the infancy of my journey into macroeconomics. It was written on the 16th of April 2018 and is in essence my basic understanding of the current macroeconomic environment. I created this report as content for the Traders Club at my university which is majority at a novice level (as am i ). As a result this report does contain a lot of explanations of basic concepts

Financial Nagasaki

Interest Rates, Overvaluation,The Corporate Debt Crisis and Why We Might Be On The Brink of the next financial crisis

What Are Interest Rates And Why Are They Important?

Interest rates are possibly THE most important factor affecting the market and arguably, global macroeconomics as a whole. Interest rates not only affect equities but also, every other asset. To understand why interest rates are so important we have to understand what interest rates are.

An interest rate is the cost of borrowing money. It is essentially the cost of capital. When we change the cost of capital, we alter the assets priced off of that cost of capital. The main asset we are focused on (being traders) would obviously be equities. We will address the matter of asset (mis)pricing later but for now it’s important we keep this assumption in mind: When we screw with the cost of capital, we screw with the assets priced off of the cost of capital.

The FED Rate

When we speak about interest rates from an equities perspective, for all intensive purposes, we are referring to the FED rate. When we say interest rates have been hiked (raised) or lowered, this is the rate we are referring to. The definition of the federal funds rate is as follows:

“The Federal Funds Rate is the interest rate which banks charge one another for 1 day (overnight) lending. This American base rate is set by the market and is not explicitly laid down by the FED. By withdrawing or adding funds to the money supply, the FED tries to bring the effective federal funds rate into line with the interest rate that it is striving for. If the FED’s monetary policy alters the base rate, that usually affects the interest rate on various products such as mortgages, loans and savings”

-http://www.global-rates.com/interest-rates/central-banks/central-bank-america/fed-interest-rate.aspx

From this we can gather two things:

1. The FED rate affects every other interest rate.

2. The FED rate can and is manipulated by the fed. As many know from their introductory macroeconomics course, there are two interest rate environments.

Low interest rates = Interest rates are lowered to stimulate economic growth. The lowering of interest rates is called expansionary policy. The main reason why lower interest rates stimulate economic growth is because the cost of borrowing is now cheaper — as a result spending and consumption increases. High interest rates = Interest rates are raised to cool off an overheating economy. Everything we have said thus far about low interest rates, is exactly the same but in the inverse applies for high interest rates

The global economy has historically been in a period of prolonged low interest rates for years. Interest rates were lowered and kept low. The side effects of this which we now witness is another potential global financial crisis. There’s a kind of beautiful irony in the fact that what we have done to recover from a financial crisis could very well be the cause for the next financial crisis.

Why Have Rates Been Kept So Low For So Long?

Now that we know what the FED rate is, let’s have a look at this graph:

There has been an obvious very strong downtrend in interest rates since 1980. Since about 2006, we witnessed what would be the start of a prolonged period of dramatically low interest rates and after 2008, we witnessed interest rates nearing and equal to 0%. Up until very very recently (at about the start of 2015) interest rates started rising from their seemingly infinite slumber. Since then, interest rates have been going nowhere but upward. This is a very important fact to remember for the remainder of this report: We are in a period of increasing rates after a prolonged period of interest rates near 0%

Now onto why rates were lowered to 0%. Most of us are aware of the global financial crisis of 2008 that it was as a result of the housing bubble bursting. It was the worst financial crisis we have seen. The “too big too fail” banks would have been as good as dead if they weren’t bailed out. This left the economy in a terrible place and drastic measures were put in place to save the economy. This is what lead to the FED’s Zero Interest Rate Policy (ZIRP).

ZIRP was a mechanism for boosting economic growth under basic Keynesian monetary theory. This extract from Investopedia (https://www.investopedia.com/articles/markets/060816/us-interest-rates-why-rates-have-been-low-long-time-gs-jpm.asp) explains the underlying assumptions very well:

“This is classic Keynesian monetary theory: discourage savers by lowering rates, forcing them to spend, encourage spenders to spend even more through cheap borrowing costs and drive investments from safer assets, such as Treasurys and certificates of deposit (CDs), into riskier equities or junk bonds” (This last part is one of the most important assumptions for the rest of the report).

The above chart is a beautiful illustration of the ZIRP era. During the ZIRP era, interest rates were kept between 0 and 0.025. This lasted seven years, between 2008 and 2015. During this period, companies took on boatloads of cheap debt, consumption and economic growth skyrocketed and the stock market enjoyed (and is still currently enjoying) one of the greatest bull markets of all time. What is also important to realise from this graph is that since 2016, the FED rate has been rising. This plays a major part in the rest of our story

The Mispricing of Equities Under ZIRP

When we screw with the cost of capital, we screw with the assets priced off of the cost of capital. To understand this, we have to understand exactly what equities are “priced off of” and what it means. This brings us to the concept of the Risk Free Rate.

“The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.”

-https://www.investopedia.com/terms/r/risk-freerate.asp

What better asset to suit this definition than the US 10 year Treasury Bill?

The US 10 year Treasury Bill is a bond backed by the US government. It is one of the most frequently traded and analysed bond on the marketplace and acts like a kind of benchmark for yeil You are guaranteed to receive your initial investment at expiry plus interest. “This sounds like a dream investment to anyone, no risk and guaranteed return, why doesn’t every investor — personal and institutional — just buy 10 year T-Bills and hold them till maturity?” is probably what you’re thinking. This is because the return on this investment — the yield on these bonds — has been pathetic to say the least. To be specific, yield on a 10 year T-Bill is currently 2.79%. Yield has been too low for too long as we can see from this graph.

This has also caused investors to seek out yield in the riskiest of places — Junk bonds. Junk bonds have been extremely popular in recent years due to them being the only place where bond investors can seek out high yield.

When investors can’t get return from their yields (which they obviously haven’t been getting for the past few years) they turn to other sources of return. Mainly the stock market. Historically, equities have returned vastly higher amounts than yield. Now as opposed to the risk free profile of bonds, equities are one of the riskiest assets out there. An investor has to go through the effort of reading yearly reports and analysing balance sheets and even then, your chosen stock(s) can go to 0. Why do they do this exactly? To give you an idea why, the S&P 500 has returned roughly 200% since 2009 — a 10 year period. Very simply, yield has been too low for too long, investors have turned to equities for years , buying more equities and ever increasing the price of these equities, resulting in this 200% return you now see.

To understand why equities are intrinsically mispriced however, we have to understand the difference between bond yield and bond prices. There are two key important factors here:

Bond Yields are tied to the macroeconomic environment and inflation — Under a shaky macroeconomic environment, bond yields are low. This has been the case for years until very recently. We can think of our friend, the housing bubble: we think of that funny little thing we call the “Asian Contagion”. The macroeconomic environment has been far from stable and this is one of the main causes for prolonged low yield. There are other reasons why bond yields have been so low and this is a great resource to read about why:

https://www.ft.com/content/2b3c6398-7f3f-11e6-8e50-8ec15fb462f4

These other reasons are: Quantitative easing and demographics. These will not be discussed in detail. The most important assumption to take note of is this: bond yields have been depressed for years. To paraphrase from the article,

“The steady downward trend in US Treasury yields is one of the most lasting and reliable phenomena in finance; scarcely anyone trading bonds today can remember a time when yields were not trending downwards”

2. Yield has an inverse correlation with bond price -

This is a universal law of finance. Yield and price are inversely correlated. When bond price increases, bond yield decreases. If we put two and two together, years of extremely low yields must mean years of increased bond prices. And that is exactly what has happened — we have displayed years of a vicious Bond Bull market. The price of bonds have been rising as the price of yields have been falling.

The mispricing of equities lies in this combination of depressed low yield and high bond price. We know that yield are very low and bond prices are very high. Coming back to our earlier assumption, a bond is in essence a risk-free rate of return. The main alternate source of return — stocks — are hence priced off of bonds and if bonds are expensive, stocks are going to be even more expensive because of their risk profile as stocks represent the opportunity cost of the risk-free rate. This in very simple terms paints a broad picture of the mispricing of equities as a result of low yield and high bond prices. This has resulted in a massive bull stock market, one that some are calling the biggest stock market bubble of all time.

The Stock Market Bubble Caused By The ZIRP

To reference an earlier part of this report, “… drive investments from safer assets, such as Treasurys and certificates of deposit (CDs), into riskier equities or junk bonds”.

What we now know is that yield-starved investors have left bonds in a large exodus and flowed into equities in large quantities as a result of low interest rates. This has caused a magnificent bull market in recent years.

This is a perfect illustration of the bull market. Above is a 16 year chart of SPY. SPY is a very important equity. It is an ETF. One of the most frequently traded and owned ETFs on the market. SPY tracks the S&P 500, one of the major US stock indices which tracks 500 US stocks. It is safe to say that the return of SPY represents the return of the stock market as whole. And the stock market as a whole has returned about 200% since 2000.

Now what is a stock market bubble and why are we in one? A stock market bubble is categorized by a rapid and aggressive increase in stock prices followed by a contraction.The last stock market bubble was the “Dotcom” bubble in 2000, where technology stocks were driven up to crazy valuations. Valuations of stocks are a measure if stocks are “cheap-undervalued” or “expensive-overvalued”. The most widely used and arguably most important valuation ratio is the PE ratio. The PE ratio measures the current stock price relative to its per-share earnings (this fundamental known as EPS — earnings per share — is one of the most important fundamental indicators). It is also known as the earnings multiple.

High earnings multiples do not necessarily mean an overvaluation, it is only natural to pay a higher earnings multiple for companies that earn more, which is why the PEs of stocks in the tech sector are higher than those of other sectors. We can however identify when stocks are trading at irrational valuations.

This is a graph of the Shiller PE ratio of the S&P 500. It is more reliable than the vanilla PE ratio as it uses average inflation-adjusted earnings from the previous 10 years. While nowhere near the ridiculous valuations of the 2000 Dotcom bubble, from this we can tell that stocks on average are currently trading at 31.40 times their earnings. A number so large that anyone would be able to spot the overvaluation. Additionally, the Shiller PE ratio is 88.1% higher than its historical mean of 16.8. Stocks are 88.1% more expensive. The two main indicators of a bubble are overvaluation and overconfidence. We can safely say that we have ticked the overvaluation box , now onto overconfidence.

Overconfidence is the belief that the stock market can’t go anywhere but up. It’s characterised by irrational periods of massive inflows into equities. It’s also characterised by what we call “buy the dip” rallies. This where after a decline in general indices, investors flood the market and engage in mass buying as “stocks are now cheap and they are bound to go back up”. This euphoria is better demonstrated in statistics from 2017:

major indices made a collective 70 new highs

There were 12 straight months of gains, not a single month in 2017 ended in a loss for any of the major indices

Now we know that that stocks are overvalued and we are potentially in a bubble. How did we get to this point?

It’s very simple: Yield is simply too low for investors so they have turned to equities en masse.

However this is not the only factor. Another main factor is this: DEBT.

The Current Corporate Debt Crisis

Please note that the global debt crisis will not be covered in this report. This refers specifically to corporate debt.

Interest rates have been ridiculously low for very long and as a result, corporates have engaged in a crazy debt frenzy. More debt allows for expansion for all for the ultimate goal of achieving higher earnings. By and large, corporates have managed to achieve this and earnings and earnings growth have been exceptionally high in recent years which has been another reason for the bull market we are currently in. However, this debt fiesta has resulted in a massively overelevered marketplace.

S&P itself has warned of a coming debt crisis. In 2017, out of a global sample of 13 000 entities, the agency reports that the proportion of highly leveraged companies represented 37% of their sample space. This is how the S&P describes a highly leveraged company: “those whose debt-to-earnings exceed 5x”.

These are companies with 500% more debt than earnings. Let that sink in…

It would be less of a problem if these levered companies were small market cap stocks but the reality is that a large portion of massive market cap stocks are highly leveraged debt giants.

I’ve compiled a small table to illustrate the extent of this problem

The debt/equity ratio is another ratio used to display the extent that a company is levered. A high debt/equity ratio is generally considered over 0.5. The figures speak for themselves in the fact that these debt figures in the table are ridiculous.None of these tech giants have more equity than debt , this speaks miles for the amount of leverage present in the technology sector particularly. These kinds of ratios trading at the valuations that these companies trade it is very far from sane.

The companies I have chosen are not small companies by any means; they are some of the biggest market participants in terms of market cap. This shows the large scale problem of our debt crisis. These figures are actually ridiculous and there is a very real possibility of default here. Companies were able to achieve such a ridiculous amount of leverage because of the years of extremely low interest rates

How Does This All End?

Here is our story thus far

Interest rates have been kept near 0 to stimulate economic activity.

This has pushed investors by large out of interest-bearing products into equities.

This has result in a mispricing of equities caused by the massive demand of them.

This has resulted in a perpetual bull market and a stock market bubble.

This has also caused a large scale corporate debt crisis.

This is a very harrowing picture, we’ve come to the end of our story and the ending is far from happy.

Remember that the graph showing near zero interest rates. This graph is one of the most frightening things I have ever seen.

Financial nagasaki 2018,Colorized

This is the situation that we are in now. The years of near zero interest rates “worked”. Consumption has increased and economic growth definitely has.

The US is showing an economic top with unemployment reaching all time lows and growth and production showing all time highs. With this comes higher inflation. The initial function of the fed rate is to control inflation by changing the cost of “money”. We are now in the current situation. These two reasons, economic growth and inflation is why the fed rate has, is and will continued to be hiked (raised).

Why rates have been rising:

Crescendo-like economic growth has reached its pinnacle. Gone are the days of a depressed economic growth and low inflation. Inflation is rising and economic growth has peaked.

Because of this there is simply no reason for rates to be low anymore and to control inflation; rates will need to be hiked.

The first part of this write-up covered the effects that low rates have on the economy. Now we need to understand what happens when we raise these rates.

Oh what a tangled web we weave when first we toy with interest rates.

Rising rates signify a healthy economy and we know that yield loves a healthy economy. With higher rates, bond yields and other interest bearing products will rise with them. With bonds (specifically being T-bills) becoming more and more attractive, the opportunity of holding stocks will fall and investors will return to bonds for their stable reasons. This is the reason why stocks have performed the way they have in the past, bonds were ugly and we didn’t want them. When bonds start to look more attractive through higher yields, it will lead to large scale selling in the stock market and the potential popping of the stock market bubble.

With higher rates, consumption will decrease significantly. At the end of the day, consumption, above all, is what drives corporate earnings — the shiny corporate earnings that have been powering the bull market higher and higher in recent years. Depressed earnings could be another catalyst for a stock market selloff.

“Bull markets don’t die of old age, the FED kills them”. Bull markets don’t last forever. Our bull market has mutated into a stock market bubble. With the end of the bull market in equities because of higher yield will come the popping of the stock market bubble.It’s only a matter of time before investors come to their senses and realise that the party is over. Until investors realise that valuations are irrationally high and that it’s time to sell.

There is a very real possibility that the rising of rates will also cause the next debt crisis. Debt is being issued to corporates of very low credit worthiness as our table illustrates. All this debt has been issued under the assumption of near zero rates. When rates rise it will affect debt and the ability to pay off debt in the following ways:

Raised interest rates will decrease companies ability to settle debt in general regardless if companies are in bad financial shape or not. Even companies with the highest grade investment bonds will be squeezed under high rates as there will simply be less money available. With decreased consumption will come decreased earnings

The highly popular high yield junk bonds will be at great risk. These junk bonds are those of corporates with the lowest levels of credit worthiness. These are bonds at the risk of actual default if rates rise as the ability for these companies to pay of corporate debt will drastically decrease. Remember that these are companies currently in bad financial states at the best of times. We might see a widespread default in junk bonds.

Floating Rate debt. Companies with floating rate debt will quite literally be vaporized. Floating rate debt is a debt instrument with a variable interest rate tied to a benchmark, most widely being the LIBOR rate. Very simply, the interest payments on this debt can skyrocket if the benchmark interest rate increases. Most companies with floating rate debt are small-mid cap stocks however there are large cap companies with a portion of their debt being floating rate.

In closing, no-one can predict the future. This is just the current conditions we are currently in. The rate at which the economy explodes all depends on the speed at which rates are hiked. It could all end in a magnificent explosion of default and selloffs or it could be a casual bleeding out. For now we can only observe this wild ride and see where it takes us.

Return isn’t everything, It’s the only thing.

Keeno Ruark Koopman