The Fed is in a tight spot.
We give Ben Bernanke and team a lot of credit for successfully delaying a prolonged global economic recession following the worst financial crisis of our generation late last decade, one that swallowed up such household names as GM (GM) and AIG (AIG), but such policies always come with unintended consequences. New Fed Chair Janet Yellen may have to deal with the true aftermath, and it’s been thrust upon her, perhaps unfairly.
With interest rates on fixed-income products near the lowest they’ve been in history, retirees and near-retirees, after suffering significant capital losses during the Financial Crisis, have been lured into higher-yielding dividend-paying equities, the prices of some almost completely supported by debt-infused dividend policies. What’s worse, many retirees and near-retirees have seemingly been schooled by their financial advisors to completely ignore market volatility and focus on long-term goals, with the assumption that the income streams associated with these lofty high-yielders are supported by organic means.
The problem is that with respect to most MLPs, the preferred vehicle of choice for some retirees and near-retirees seeking income, it is our contention that their equity prices are being propped up by a distribution that can only be sustained via external capital market issuance in the equity or debt arenas. Not only that, but most capital-market-dependent dividend payers are being priced as fixed-income vehicles on “growing coupons” that are, in our view, financially-engineered, inorganic dividends. Said differently, such equity instruments are fetching valuations that have become materially disconnected, in our view, from traditional organic free cash flow measures of their underlying operations. With their distributions used as “growing coupon payments” for retirees and near-retirees, their equity prices have inevitably become more debt-like than could have ever been imagined.
A contractionary monetary tightening cycle, in our view and by extension, will be devastating to those same retirees and near-retirees that flocked into high-yielding dividend payers, after losing significant capital during the Great Recession. Not only will these “debt-like” dividend-paying equities be repriced substantially lower in the event of contractionary monetary policy as interest rates rise, but the lending environment will also tighten under such conditions, in our view, further exacerbating tangible project NPVs and organic free cash flows of these entities as well. Such conditions, in our view, would spell massive declines in some of the highest dividend-paying stocks as 1) the debt-infused bubble is popped (and shares/units are repriced lower and re-valued as “true” equities), and 2) their economic profit streams are squeezed due to higher borrowing costs and costs of capital. The Fed has been talking about talking about raising rates for a long time, but financial advisors and most market observers continue to shrug it off, putting their faith in long-term thinking and the view that all income streams are created equal.
We know this not to be true.
A fear of causing asset flight out of high-yielding equities (and the stock market as a whole) and doing further damage to retirees’ and near-retirees’ livelihoods seemed like a great reason for the Fed to continue to delay contractionary policy for these many years. However, in doing so, it simultaneously delayed building an effective “war chest” of monetary tools that it would be able to use to fend off the next crisis, which unfortunately, is already here in the form of the “Asian Contagion” of 2015/16. If the Fed had decided to tighten gradually the past few years, it may be sitting at a federal funds rate a few percentage points higher than today’s, and instead of the markets gyrating in fear of a rate hike right now, they’d be comforted knowing that further tools can be used to assuage Asia’s troubles from completely infecting the US.
The sad reality for indexers, however, is that it’s very likely we’re headed lower no matter what the Fed does in September or in 2016.
For one, if the Fed starts to raise interest rates, we’d expect significant asset-flight out of equities, led by selling in unsustainably high-yielders spreading to speculative “lofty-multiple” entities and beyond, something we’ve been talking about for some time. In fact, just yesterday, one of the largest pension funds in the US, CalSTRS, was reported to be considering large asset allocation shifts away from equities, likely the first public announcement of many more to come. On the other hand, if the Fed stands pat and does nothing, the markets will interpret the impact of the “Asian Contagion” as a real tangible threat to US economic growth (which it is, in our view) and start factoring in reduced earnings expectations, which will eventually hurt equity prices and stimulate even more selling, laying the groundwork for a bear market, which we believe we are in.
But no matter what the Fed does, there are two connected and supporting data points that speak to a coming contraction in US GDP, not in the third or fourth quarter of 2015, which may be fine, but in 2016 as global events from Asia begin to sprawl. Budgets at the largest corporations aren’t set overnight, and if dislocations in the market, like those that just happened in China and the US these past few weeks, have paused growth initiatives in the executive suite (which we believe they have), the ramifications probably won’t show up until several months or quarters later. With the days of 2015 already counting down, 2016 has now taken center stage.
But what are these two data points that we’re worried about?
First, Moody’s talked in its August 27 Weekly Market Outlook that not only was the corporate credit cycle past its prime, but that “financial market turmoil has brought corporate bond issuance to a near standstill.” Second, the Wall Street Journal offered yet another supporting data point the other day reporting that Franklin Templeton has “seen new issuance evaporate at the moment.” Though some of the strongest corporates such as Apple (AAPL), Microsoft (MSFT), and Cisco (CSCO) remain flush with cash and continue to invest, other sectors are dependent on debt funding for growth, namely most energy MLPs. Other sectors, including the broader energy and basic materials arenas, are dependent on debt funding for survival under current conditions rather than growth.
That may not be the only takeaway from these two data points, however. The logical extension of a slowdown in new debt issuance, which is a precursor to investment and growth, is that businesses are growing more cautious on the broader economic climate, and that alone may be all that is required to actually have a tangible, slowdown in US gross domestic product. Throw in the contagion from China’s equity market collapse, which has already spilled over to South Korea and Australia, and we are now staring down the probability (not possibility) of economic contraction in the US in 2016. The day has finally come, in our view, and data points for the remainder of 2015 matter little to what could be in store beyond.
Obviously, there is never a good reason to panic, in our view, and economic prognostications are fraught with risks and uncertainties, but as with CalSTRS, taking a realistic look at the prospect of global equity performance in the coming years may be a wise move now–while the going is still good. Do you really think that the next 30 years in the equity markets will be as good as the previous 30 years, given that interest rates are starting at near-0% today, US stocks are still near all-time highs, and the advent and development of the greatest boost in workplace productivity that humankind has ever seen in the form of the personal computer is now behind us?
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