Download Trump Trade Will Accelerate Historic Credit Bust

The biggest credit boom in history
US corporate cash flow/debt collapses as CFOs leverage balance
sheets
While real investment collapses
CFOs just focus on stock prices
No Wonder S&P credit downgrades explode this year
The next bust period in the credit cycle has already begun!
“There are three big “tells”
The Trump Trade will add in more problems, accelerating the historic
credit bust that has already begun
Higher interest rates increase the burden of new record debt levels
Higher interest rates will reduce borrowing which will slow the
economy
Higher interest rates will strength the dollar which will reduce net
trade, and lower import costs which raises the real interest rate and
lowers growth
Dr Lacy Hunt believes Trump’s economic impact will be minor, the
declining secular trend in Treasury bond yields remains intact
Summary and conclusion
----------------------
Trump Trade Will Accelerate Historic Credit Bust
The violent rush to economic judgement after the Trump election win is highly
questionable. On further examination it could even be reversed before long. Just
the recent market moves themselves constitute a tightening in policy at what could
be a very bad time. It could even precipitate an acceleration in the bust phase of
the biggest credit cycle in history.
The biggest credit boom in history
“Between 2005 and 2015, U.S. corporations exploited artificially low interest
rates to borrow unprecedented amounts of money…
Before the mid-2000s, U.S. corporations had never borrowed more than $1
trillion in a year. They did so twice, in 2006 and 2007 – the "boom" years.
Maybe you'll remember what happened next – a huge bust, the worst
recession since the Great Depression.
So what did Obama do to heal our economy from these wounds? He
engineered an even bigger debt bubble…
First, he doubled the amount of outstanding, freely trading U.S. Treasury
debt (from $7 trillion to $14 trillion). He directly borrowed more money than
all the other U.S. presidents ever borrowed before, combined. Worse, his
economic team led the Federal Reserve to hold down interest rates to
essentially zero.
What happened next will scar our economy for a decade, at least. Every
year between 2010 and 2015, U.S. corporations borrowed more than
$1 trillion. In 2014 and 2015, they borrowed nearly $1.5 trillion.
Junk bonds had almost never made up more than 20% of corporate-bond
issuance. But during the six-year "Obama debt boom" of 2010-2015, highyield bonds made up more than 20% of issuance in every year except the
last (2015).
Year
% Junk
2010
25%
2011
22%
2012
24%
2013
24%
2014
22%
2015
18%
Source: Securities Industry and Financial Markets Association (SIFMA)
But it's not just that record amounts of debt have been underwritten. It's the
quality of that debt that's the real problem.
You see, most big banks and insurance companies aren't allowed to buy
"junk" bonds. Therefore, most investors don't worry too much about the
junk-bond default rate.
But… what if investment-grade debt has suffered the same kind of quality
impairment?
Over the past decade, the lowest-quality tranche of investment-grade debt,
debt rated "BBB," has grown from around 10% of total investment-grade
issuance to more than 30%.
While I don't think BBB debt will default at anything like junk-bond rates,
I'm certain that during the next credit-default cycle, the annual default rate
on the lowest rung of investment-grade debt will be at least triple its former
peak (1% in 2002).
If we see three or four years of default rates at this level (say 3%), you're
going to see big losses at major financial institutions. These losses will be
more than enough to cause the collapse of at least one or two big firms.
(We're talking about $200 billion-$500 billion in investment-grade-bond
defaults.) This will send a wave of panic through the markets. Combined
with junk-bond losses, all this will dwarf the losses caused by bad
mortgages.
This big change in the underlying soundness of the corporate-bond market
guarantees that during the next credit-default cycle, losses are going to be
far bigger and hit far more companies and investors than ever before… and
much more severely.”
Porter Stansberry
US corporate cash flow/debt collapses as CFOs leverage balance
sheets
Usually, as we can see from the chart below, there is a natural limit to
corporate debt. Corporate CFOs normally cut back on debt issuance as cash
flows decline as a proportion of debt, and the gearing, or leverage, becomes
problematic.
This was a very good leading indicator for the stock market in both the 2000
and 2007 stock market bubbles. However, this time around, despite the
record amount of debt issuance, it has not happened. Cash flows/debt has
been falling for 5 years, but the stock market has continued its relentless
rise!
https://blog.variantperception.com/2016/11/12/credit-spreads-and-equity-volatility-to-rise/
While real investment collapses
It seems clear that corporate managers have used lower interest rates as
more of an opportunity to leverage their balance sheets, with more debt,
and buy back their own shares, rather than directly invest in businesses. The
chart below shows the long term collapse in US Domestic Investment,
despite the explosion in corporate debt. This explains, at least in part, the
extraordinary rise in the US stock market. It boosts earnings per share and
boosts stock prices. Both are to the short term benefit of corporate
managers.
http://www.hussmanfunds.com/wmc/wmc161114.htm
CFOs just focus on stock prices
Sooner or later all this much debt, much of it highly unproductive, is going
to be a problem. Lately corporate managers have even been accelerating
debt when there cash flow has stopped growing!
No Wonder S&P credit downgrades explode this year
The next bust period in the credit cycle has already begun!
Stansberry writes:
“There are three big “tells”:

First, total U.S. corporate debt is now 45% of GDP. That’s where the
two previous credit cycles peaked (’02 and ’08). It’s simply not
possible that the amount of credit outstanding to corporations can
grow much from here because, even at very low rates of interest,
there are not enough willing borrowers. Think about yourself. Does it
really matter if someone offers you a 2% rate on a credit card? Are
you going to go into debt for any reason? Nope.

Second, and far more important when it comes to timing, the number
of banks in the U.S. that are tightening lending standards is rising and
has just passed a critical threshold (10%). Banks tend to tighten
lending standards at the same time, at the end of a credit cycle and
beginning of a default cycle.

Third, we know for sure that a new default cycle has begun because
not only are banks tightening, but credit downgrades (by the ratings
agencies) have bottomed (in 2014) and continue to grow substantially.
Likewise, outright default rates have bottomed and continue to grow
rapidly. Morgan Stanley’s top high-yield bond analyst (Meghan
Robson) believes the default rate in high yield will hit 14% by the end
of 2017 (it was basically zero in 2014). She also says the total default
rate will peak at 25% annually within five years.”
The Trump Trade will add in more problems, accelerating the historic
credit bust that has already begun
1. Higher interest rates increase the burden of new record debt
levels
But this has happened while interest rates have fallen.
So most investors don’t understand the enormous interest rate burden of
higher bond yields. The last time bond yields were significantly higher the
debt was nowhere close to where it is today. A rise in yields of just 1%
increases the interest cost of just government debt by around $200 Billion!
http://danielamerman.com/va/Conflict.html
The bigger Trump’s deficit spending is the higher interest rates will be and
so also the extra interest cost of the deficit!
2. Higher interest rates will reduce borrowing which will slow the
economy
It’s already happening just in housing. The chart below shows the immediate
response in terms of lower mortgage applications.
http://www.zerohedge.com/news/2016-11-16/mortgage-applications-crash-30-borrowing-rates-surge
3. Higher interest rates will strength the dollar which will reduce
net trade, and lower import costs which raises the real interest
rate and lowers growth
http://www.zerohedge.com/news/2016-11-15/import-prices-decline-record27th-month-china-exports-most-deflation-6-years
http://www.zerohedge.com/news/2016-11-07/china-trade-data-disappoints-again-despite-plungingyuan
Dr Lacy Hunt believes Trump’s economic impact will be minor, the
declining secular trend in Treasury bond yields remains intact
“The most potentially dynamic component of the Trump plan is the reduction
in tax rates. The plan calls for a $500 billion decrease in taxes over the next
ten years. With a tax multiplier of –2, there would be a lift in economic
growth of $1 trillion over the next ten years for an economy that is on a
growth path of about $5 trillion over that same time frame. As such the
annual growth could be boosted from $500 billion a year to $600 billion. This
stimulus will take a considerable amount of time to work through the
economy and the positive contribution requires that monetary conditions
remain favorable, not adversarial.”
As we discussed above they see that markets have already tightened to
offset the growth additives we don’t even have yet. Then they conclude:
“Markets have a pronounced tendency to rush to judgment when policy
changes occur. When the Obama stimulus of 2009 was announced, the
presumption was that it would lead to an inflationary boom. Similarly, the
unveiling of QE1 raised expectations of a runaway inflation. Yet, neither
happened. The economics are not different now. Under present conditions, it
is our judgment that the declining secular trend in Treasury bond yields
remains intact.”
http://ggc-mauldinimages.s3.amazonaws.com/uploads/pdf/OTB_Nov_16_2016.pdf
Summary and conclusion
Markets have rushed to conclusions following the Trump election, which has
produced extremely rare market behavior.
This has been a rush to judgment on policy that has not yet even been
determined and even when it is, will be months to implementation in the
future. Yet we can see that this futurism is actually already having
immediate NEGATIVE impacts.
Furthermore, it comes at a very bad time for the extreme conditions in the
already developing biggest credit bust in history.
Investors need to tread very carefully in these very untested and challenging
conditions.
If the Trump Trade just accelerates or even sets off the Big Trade, then how
much stimulus will Trump have to provide? Will the interest cost from the
deficit financing even be bearable at higher yields?
Investors should wait for much more evidence before jumping onto the
Trump Trade. It may well be a better strategy to plan on fading the Trump
Trade as its momentum fades with Stansberry’s Big Trade which targets the
historic credit bust that has begun.
Here is the Goldman Financial Conditions index (inverted) showing some
tightening in the US. It shows that index compared with the S&P 500 in the
chart below.
Something's got to give.