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Last week, Bank of America Corp.’s head of U.S. equity and quantitative strategy, Savita Subramanian, said something very interesting about the S&P 500:
“The S&P 500 has essentially turned into a 36-year, zero-coupon bond,” Subramanian said in an interview on Bloomberg TV’s Surveillance. “If you look at the duration of the market today, it’s basically longer duration than it’s ever been. This is what scares me.”
While we are not exactly sure how Bank of America comes up with “36-year zero-coupon bonds” (we assume it is some sort of beta analysis), it appears that Ms. Subramanian is telling us many companies are leveraged to the hilt and a move up in interest rates and a widening of credit spreads will compress margins, increase the cost of capital, reduce earnings, and ultimately equity valuations. This very insightful observation not only sheds a bright light on the fragility of equity valuations but should also send chills down the spine of investors' heavily leveraged loans and high-yield bonds.
In these markets, there are many companies that cannot generate enough cash to meet debt service, let alone have some cash flow left over after they service their debt. We continue to point out that about $400 billion leveraged loans reside in open-end mutual funds that promise timely liquidity to investors upon request. There’s also plenty of investor capital in high-yield bond funds. We saw what was going to happen to that market when the music stopped and liquidity evaporated last March. Actually, we didn’t see it because the Fed and Treasury bailed everyone out before it happened! Last March, the Fed saw (amongst other things), that the multi-trillion, high-yield corporate debt market’s liquidity went to zero and perhaps finally realized there is indeed a problem that threatens the financial system.
We have a strong feeling the Fed understands the concept of equity market rate duration and perhaps they even learned something from the March 2020 panic, given that a sharp rise in borrowing rates and credit spreads, coupled with a bout of illiquidity could be a complete disaster, similar to 2007-2008. Unfortunately, the Fed’s policies have not only done nothing to address this yawning problem. Quite the opposite.
The Fed’s super accommodative monetary policy has made the exposure to this risk worse than it was last March. Many of what are referred to as “zombie companies”—companies that have negative cash flow after servicing their debt—or “zombie-zombie companies” that have negative cash flow before they even get around to servicing their debt, have been able to refinance existing debt and raise additional debt as interest rates remain at rock bottom along with high-yield corporate credit spreads. While refinancing for these companies is net “good," adding more debt to them (or adding new corporate borrowers) certainly is not, especially if earnings and balance sheet health have not improved.
The Fed is often accused of enabling “moral hazard” whereby investors take outsized risk, win when it goes their way, and don’t pay too much when things go wrong because the Fed is there to bail them out. There does not seem to be much reason to think that things would be different if the markets ran into trouble again. Therefore, we shouldn’t be too worried about higher interest rates anytime soon, unless….
President Biden and his advisors have been strangely quiet on who they will put forward as Federal Reserve Chairman as Jerome Powell’s first term is ready to expire. One would think, considering how incredibly accommodating the Chairman’s monetary policy has been throughout his term, especially during the pandemic, besides the odd inflation bug or Larry Summers, Powell has kept the printing press cranking which in turn allows Washington, DC to spend like drunken sailors and Wall Street to supercharge earnings. Powell has also been very supportive of nearly every program that has been designed to ease the great pain of the pandemic on citizens and businesses.
However, if you listen to the progressive wing of the Democratic party, you’d think Ebeneezer Scrooge was sitting at the head of the Fed table. Recently, members of the Democratic Party’s Progressive Caucus stated:
“As news of the possible reappointment of Federal Reserve Chair Jerome Powell circulates, we urge President Biden to re-imagine a Federal Reserve focused on eliminating climate risk and advancing racial and economic justice,”.
It appears that the progressives would reimagine a Federal Reserve Chairman as The Wizard of Oz. A name that seems to be getting put forward is Federal Reserve Governor Lael Brainard. Perhaps Biden giving a nod to progressives like Senators Elizabeth Warren and Sherrod Brown, who seem dissatisfied with Jerome Powell although we really aren’t sure what more the current Chairman could do to support their causes. Nevertheless, the progressive wing most probably views Powell as a product of Wall Street while Brainard is a product of academia and government. Since Governor Brainard is viewed by the financial markets as one of the most dovish members of the Board, if she is nominated over Powell, the markets may read this change as inflationary and thus drive up the long end of the yield curve. Furthermore, if we buy into the corporate risk zero-coupon bond theory laid out by Bank of America, this could bring about a significant correction in stocks and corporate debt.
We believe the odds of a change at the Fed are low. However, it is certainly something that bears watching given the highly leveraged nature of corporate bonds, loans, and equities.
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