2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

[ProdigyofZen]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Chart does not work.

[EJ]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Net Det and Equity composition of the aggregate S&P500...


EJ - The confusion I have with this is outlined in my chart above... Net Debt has been consistently declining across all listed S&P500 stocks since the financial crisis.

Your explanation sounds to me as if there is rapid growth in bond market credit. The only way I can reconcile such growth, alongside corporate balance sheet de-leveraging (as shown by my chart above), is that not only are balance sheets of listed corporates getting better, but the debt mix is also shifting - from bank debt, to bonds. This is what I am also seeing in Australian listed corporates, especially REITs. The motivation is to move away from bank debt where companies can at best get 3-5 year debt, and increase avg debt tenor by moving in to bond markets. This was a lesson learned the crisis from not having long-term debt to match long-term assets.

So in summary, your chart explains how more corporate credit is being issued - but when combined with my chart, it shows that it's a "mix of debt" shift away from bank debt, as opposed to a re-leveraging of the corporate sector.

EJ, would you agree/disagree with this explanation? I am really keen to understand where I might be wrong.

Your thoughts are much appreciated,
Damon

I don't understand your chart. What does Net Debt refer to? Can you tell me where the data come from and what they refer to?

The standard source is the Fed Flow of Funds available here. Corporate balance sheets displayed a reduction of debt liabilities relative to assets from Q1 2009 to Q4 2010 but have been rising since.

[dcallaghan89]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

I don't understand your chart. What does Net Debt refer to? Can you tell me where the data come from and what they refer to?

Apologies for being unclear.

The data is taken from Bloomberg, and is aggregated from all of the listed companies that make up the S&P500 combined.

Equity + Net Debt = Total Invested Capital, of all the stocks that comprise the S&P500. *Note that Net Debt referes to (total Debt - Cash)... total debt includes bond market & bank debt.... so if debt was rising then cash would have to be rising faster to create the downward trending line seen in the chart I posted.

Invested Capital has been constant since the financial crisis. Seeing your chart, I thought that debt was going up - therefore equity must be going down (ie, equity buybacks that US listed companies have been doing). However, when I broke apart the composition of Invested Capital it clearly shows that net debt has been falling, and equity has been rising.

Hope that clears it up. If you wish, send me a private message with an email to contact and I can have more data sent in excel - very hard for me to upload charts from work (took me ages to find a source where I could upload the one above!)

[Polish_Silver]

Corporate debt higher in 1970?

The chart seems to mean corporations are in much safer territory now than in 1970. Liabilities to assets was much higher then!

I don't get that at all!

The two charts seem to have the same title, but look radically different. Haven't been able to copy and paste them in yet.

[EJ]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Apologies for being unclear.

The data is taken from Bloomberg, and is aggregated from all of the listed companies that make up the S&P500 combined.

Equity + Net Debt = Total Invested Capital, of all the stocks that comprise the S&P500. *Note that Net Debt referes to (total Debt - Cash)... total debt includes bond market & bank debt.... so if debt was rising then cash would have to be rising faster to create the downward trending line seen in the chart I posted.

Invested Capital has been constant since the financial crisis. Seeing your chart, I thought that debt was going up - therefore equity must be going down (ie, equity buybacks that US listed companies have been doing). However, when I broke apart the composition of Invested Capital it clearly shows that net debt has been falling, and equity has been rising.

Hope that clears it up. If you wish, send me a private message with an email to contact and I can have more data sent in excel - very hard for me to upload charts from work (took me ages to find a source where I could upload the one above!)

This is where one has to be careful when reviewing aggregate data as presented by a mainstream business media as these tend to interpret and present data in line with an agenda. A common refrain is that there are piles of "cash on the sidelines" which is true except that there are even larger piles of debt.

We start with the data in detail.

If Net Debt refers to Debt - Cash, debt means all payable liabilities on the balance sheet. From the Fed Flow of Funds this means:

The above is comprehensive except that owing to a bug in the Fed charting software a small liability in taxes payable is not included. At $9.6 trillion corp. borrowing from the credit markets is by far the largest component followed by $6.6 trillion bonds outstanding and $4.2 trillion in Miscellaneous Loans and Advances.

It's worth noting that over time, total liabilities tend to equal total financial assets, with the net assets (net worth) being non-financial: inventory, trade receivables, real estate, etc.

From a macro economic standpoint, the relevant question is: What happens when the stock market declines and the ratio of market value of equities to debt rises?

A rising stock market allows corporations to borrow more. A falling stock market does the opposite.

For the past several years, low and falling interest rates have caused equity values to rise, and rising equity values have allowed corporations to borrow at low interest rates to meet demand for higher yield debt. In the future two processes are likely to coincide and potentially re-enforce each other: equity prices fall, equity values fall, ratio of debt to equity rises, corp. must raise interest rates to attract buyers, banks will raise interest rates to offset default risk resulting in higher borrowing costs. The cheerful process set in motion by QE will then run in reverse.

A few additional charts of possible interest.

[Polish_Silver]

Corporations buying stock back

. . .. A common refrain is that there are piles of "cash on the sidelines" which is true except that there are even larger piles of debt. k


AA rising stock market allows corporations to borrow more. A falling stock market does the opposite.

For the past several years, low and falling interest rates have caused equity values to rise, and rising equity values have allowed corporations to borrow at low interest rates to meet demand for higher yield debt. In the future two processes are likely to coincide and potentially re-enforce each other: equity prices fall, equity values fall, ratio of debt to equity rises, corp. must raise interest rates to attract buyers, bss

My understanding was that banks would not issue home loans to borrowers based on stock collateral, because stock prices were too volatile downwards. Yet, you seem to be saying that corporate bonds are issued using the stock as collateral. It is not the stock held by the general public that creates this crisis, but the stock owned by the corporation itself, because a decline in stock price means the net worth of the company can become negative?

So if they company borrows money to buy stock, they become more and more sensitive to stock price declines. And if they need to roll over the debt, they won't be guaranteed the same low rate, or will they? Surely, it doesn't take EJ to figure this out. Is corporate leadership that weak?

[vinoveri]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

A rising stock market allows corporations to borrow more. A falling stock market does the opposite.

For the past several years, low and falling interest rates have caused equity values to rise, and rising equity values have allowed corporations to borrow at low interest rates to meet demand for higher yield debt. In the future two processes are likely to coincide and potentially re-enforce each other: equity prices fall, equity values fall, ratio of debt to equity rises, corp. must raise interest rates to attract buyers, banks will raise interest rates to offset default risk resulting in higher borrowing costs. The cheerful process set in motion by QE will then run in reverse.

Can't the Fed mitigate this by entering and buying the corp bond and credit markets to maintain low yields, like it is doing with treasuries and MBS?
It can even buy equities if it needs to support a controlled descent. Swap lines with other CBs who are not constrained in their asset purchase is a neat trick to avoid the letter of the law.

[lektrode]

Re: Corporations buying stock back

... Surely, it doesn't take EJ to figure this out. Is corporate leadership that weak?

in a word?

Y.E.S.
they are too weak in the 'ethics' dept, mostly - and its all due to the need to make the quarterly numbers with a 'little tweak of the materials/ingredients' here, a bit of massage of the marketing message there 'new and improved' now meaning made cheaper/less durable/tasty/whatevah - in an effort to shave nickles/dimes off the top of the line here n there - with the 'results' being they award themselves MILLIONS in bonuses -

and VOILA!!

its END JUSTIFIES THE MEANS time

also suggests most of em are seeing what they were seeing the last time this happened (2007-08), doesnt it?

[Chris Coles]

Re: Corporations buying stock back

And then you have to add into the equation the "at par" value of the original share certificate; which is, in point of fact, the only input to the original capital base of the non financial corporation. All additional value, created by the "Market", in extremis, is entirely ephemeral. At the end of the day, there is a very long way to fall back down the graph when the market goes into reverse.

[dcallaghan89]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

EJ - thanks for the data & discussion. I've realised the difference is that your data is strictly non-financial corporations. My data was the S&P500 aggregate, which also includes financial companies (banks, insurance, diversified financials, REITs). According to my data (can't publish charts from work PC - sorry) it looks like the entire index's total liabilties (and total debt, depending on the index) is definitely rising - but the FINANCIAL companies are broadly flat: which means that in the non-financial part of listed index's, debts & liabilties are rising faster - at a rate consistent with the Flow of Funds data.

Thank's for the clarification and discussion.

Takeaway from this - Corporate America is more highly leveraged - but not so much in the financial sector, following the crisis.

[FRED]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

EJ - thanks for the data & discussion. I've realised the difference is that your data is strictly non-financial corporations. My data was the S&P500 aggregate, which also includes financial companies (banks, insurance, diversified financials, REITs). According to my data (can't publish charts from work PC - sorry) it looks like the entire index's total liabilties (and total debt, depending on the index) is definitely rising - but the FINANCIAL companies are broadly flat: which means that in the non-financial part of listed index's, debts & liabilties are rising faster - at a rate consistent with the Flow of Funds data.

Thank's for the clarification and discussion.

Takeaway from this - Corporate America is more highly leveraged - but not so much in the financial sector, following the crisis.

As a footnote to this discussion, a chart that compares total liabilities in the non-financial corporate sector to the financial sector.

As of Q4 2013 liabilities (debt + equity) in the non-financial corporate sector totaled $36.7 trillion versus $83.4 billion in the financial sector.
With respect to total liabilities, the financial sector is 1/440th the size of the non-financial corporate sector.

[mmr]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Corporate and other debt is priced relative to Treasuries (for example, a AA-rated corporate bond might trade with a yield that exceeds a Treasury bond with the same maturity by 0.25%).

By controlling Treasury and mortgage-backed securities yields, the Fed has indirectly influenced the yield for all dollar-denominated debt (corporate and high-yield debt, securitizations, etc.)

[EJ]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Corporate and other debt is priced relative to Treasuries (for example, a AA-rated corporate bond might trade with a yield that exceeds a Treasury bond with the same maturity by 0.25%).

By controlling Treasury and mortgage-backed securities yields, the Fed has indirectly influenced the yield for all dollar-denominated debt (corporate and high-yield debt, securitizations, etc.)

Precisely correct. The "risk-free" UST sits at the foundation of the risk/yield bond pyramid. All other bonds are priced off of the UST on a relative risk basis. This is true both with respect to the shortest and longest durations.

Since 1913 when the Fed opened its doors interest rate policy has been restricted to purchases and sales of short-term treasury bills and notes with policy itself generally lasting longer than the duration of the securities purchased or sold to implement the rate policy, that is, interest rate policy generally last in either direction for six to 18 months and is implemented by purchase or sale of treasury bills of six months term or less. In fact, Section 14 "Open Market Operations" of the Federal Reserve Act restricts open market operations of the Fed to short-term government bonds as follows:

1. To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market.
2. To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.

That all changed in 2007:


The Federal Reserve's approach to the implementation of monetary policy has evolved considerably since 2007, and particularly so since late 2008 when the FOMC established a near-zero target range for the federal funds rate. Since late 2008, the Federal Reserve has greatly expanded its holding of longer-term securities via a series of asset purchase programs with the goal of putting downward pressure on longer-term interest rates and thus supporting economic activity and job creation by making financial conditions more accommodative.

• From December 2008 to August 2010, to help reduce the cost and increase the availability of credit for the purchase of houses, the Federal Reserve purchased $175 billion in direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. In addition, from January 2009 to August 2010, the Federal Reserve purchased $1.25 trillion in mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Detailed transaction level information for the MBS purchase program is available at the link below.
  • Agency MBS Purchase Program, January 2009 - August 2010
  
  
• From March 2009 to October 2009, the Federal Reserve purchased $300 billion of longer-term Treasury securities to help improve conditions in private credit markets.
• From November 2010 to June 2011, the Federal Reserve further expanded its holdings by purchasing an additional $600 billion of longer-term Treasury securities.
• Starting in September 2012, the Federal Reserve further increased policy accommodation by purchasing additional MBS at a pace of $40 billion per month.
• Starting in January 2013, the Federal Reserve began purchasing longer-term Treasury securities at a pace of $45 billion per month, following the completion of the maturity extension program in December 2012.
• In December 2013, the Federal Reserve announced that it would modestly slow the pace of additional MBS and longer-term Treasury securities purchases and would likely further reduce the pace of asset purchases in measured steps if incoming information broadly shows ongoing improvement in labor market conditions and inflation moving back toward the FOMC's 2 percent longer-run objective. Since December 2013, the Federal Reserve has announced further measured reductions in the pace of asset purchases.
• Currently, the Federal Reserve also purchases MBS under a policy announced on September 21, 2011, in which principal payments from its holdings of agency debt and agency MBS are reinvested
  in agency MBS.

Credit and Liquidity Programs and the Balance Sheet

Policy has lasted for years and has been applied to long-term debt. What happens when large scale operations to distort the foundation of the bond risk/yield pyramid for the first time in history are reversed? No one knows.

I can say categorically that the boys and girls at the Fed don't know and of course cannot because there is no precedent. They appear to me to have less than strong conviction regarding accepted theory and will attempt to manage the uncertainty by making very small, well broadcast moves.

My fear is that the tiniest changes in Fed posture will produce grotesquely outsized responses across the entire bond market. October will be a dry run, I suspect.

[dcallaghan89]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

Interesting. That's the obvious fault of only looking only at companies listed on the stock market.

[Jen]

Re: 2013 Review and 2014 Forecast - Part I: The Last Bubble - Eric Janszen

My fear is that the tiniest changes in Fed posture will produce grotesquely outsized responses across the entire bond market. October will be a dry run, I suspect.

Do you think the bipolar Bullard comments regarding more QE and the reactions in the equity and bond markets seen in October were the Fed performing psychological tests on the market? To see what they can do without the actual QE? Do you think they can/will do more actual QE or just rely on other central banks, who apparently can just buy up our equities directly?