Ian Verrender* says there’s a common feature underpinning almost every major shakeout on financial markets in recent history — debt.
Photo: Ruth Enyedi
For most investors, October was a month to remember for all the wrong reasons.
October turned into “Shocktober” as waves of panic roiled global markets and torched most, if not all, of this year’s gains.
While the fears have since abated, they haven’t entirely disappeared.
Nor should they.
For while the old adage that bull markets are built on a wall of worry is usually trotted out to placate the fearful and soothe rattled nerves, tensions within the global financial system are building, potentially grinding towards a breaking point.
There’s a common feature underpinning almost every major shakeout on financial markets in recent history — debt.
In 1987, it was the collapse of highly leveraged entrepreneurs and buyout merchants.
A decade later, a government debt crisis beginning in Thailand swept through Asia.
And in 2008, a real estate frenzy that had gripped America for years finally imploded, transmitting chaos across the globe.
The “Great Recession”, as it’s now called, was overcome via a novel, counterintuitive trick.
A debt crisis was solved by piling on a huge amount of extra debt as governments and central banks flooded the world with cash — money that helped inflate asset prices in even the far reaches of the finance world.
But was the problem really solved?
Or have we merely delayed the inevitable?
Most Australians are acutely aware that our real estate is ridiculously priced.
That it’s coming off the boil may be welcome news in some quarters but there will be plenty who will feel pain.
Our own real estate spree has made us contenders for global leadership in the household debt stakes.
Then there’s equity markets.
The ructions that spread from Wall Street across the globe last month, after a decade of phenomenal gains that pushed American stocks to dizzy new records, hit Australian stocks hard, even though we’re still well below our 2007 peak.
That’s likely to continue and our underperformance will do little to shelter us.
American exceptionalism … except it isn’t
Many in the Big Apple just can’t comprehend it.
The American economy is doing just fine, with unemployment plumbing the lowest levels in more than a generation.
US corporate earnings have been solid.
And that, they’ll tell you, is enough to justify the soaring trajectory of US stocks, and particularly technology companies, in the past decade.
Lurking in the shadows, however, is an age-old foe of bull markets.
Earlier this month, America’s central bank kept rates on hold at 2.5 per cent but made it clear it was on track to push rates higher at the next meeting in a month’s time.
In fact, the US Federal Reserve is determined to push official interest rates back above 3 per cent, to return to some kind of “normal” stance on monetary policy.
Let’s not forget, they were sitting on an official rate of zero just two years ago.
Why is that a problem?
If you’re emerging from the woods, that should be great news.
Except for one major problem — the D-word: Debt.
American businesses have borrowed like there’s no tomorrow.
Corporate debt — not including the banks — has almost doubled since 2008 and now sits at just under US$6.3 trillion.
Interest rate hikes are bad for stock markets, even at the best of times, for three reasons.
The first is that investors withdraw cash because they can earn a decent return with less risk elsewhere.
The second is that higher rates act like a brake on the economy, hurting corporate earnings.
And the third is that debt becomes more expensive, which eats into profits.
The more debt a company holds, relative to its earnings, the more difficult it becomes to survive
What have American companies done with all that debt?
When Ben Bernanke hit the emergency switch and pushed rates to zero, it wasn’t just to help out the fat cats on Wall Street although, as things transpired, that’s exactly what happened.
In an almost identical argument to the recent one we’ve been having about corporate tax rates, the then US Federal Reserve Chairman reckoned that if money was so cheap banks could give it away, companies would borrow big, invest in new plant and equipment, hire more workers and quickly get the real economy back on track.
It worked, sort of.
The only problem was that corporate America, while it was more than happy to borrow the cash, didn’t exactly invest it all, or even that much of it.
Instead, it doled out a large slice of the borrowed cash to investors in the form of dividends and by buying back shares.
Most senior executives are paid bonuses if the stock price rises.
There are two easy ways to do that.
One is to attract investors by forking out huge dividends.
The more demand for shares, the higher the price.
The second is to step into the market and buy back your own shares, further boosting the price.
American bosses embraced the idea with glee.
Borrow cash for next to nothing, hand it out to punters, watch your stock soar and reap the rewards for a surging stock price.
It was money for old rope.
This year, the bonanza to investors should top US$1 trillion, turbocharged by US President, Donald Trump’s recent massive round of corporate tax cuts.
All of which goes to prove that corporations will only invest if they can see a return on it.
They won’t invest or hire extra workers simply because they have extra cash with which to play.
The problem now is that while the resulting debt needs to be repaid, there isn’t enough extra earnings capacity to cover the rising cost of all that extra borrowing once interest rates rise.
And many of the executives who benefited from this wondrous experiment have ridden off into the sunset, saddlebags packed with gold.
Little wonder Wall Street’s money mandarins are getting twitchy.
* Ian Verrender is the ABC’s Business Editor.
This article first appeared at www.abc.net.au.
