As the coronavirus roils markets, as indexes swing down — and up — by several percentage points daily, and as interest rates get ever smaller, we’re in uncharted territory.
As Jerry Flum, CEO of CreditRiskMonitor, told PYMNTS, the stage may be set for a series of ripple effects, none of them terribly comforting.
First thing’s first: Markets look overvalued in his estimation, even against recent pullbacks.
As he told PYMNTS, consider the hypothetical situation in which a company with $50 million in annual revenues has after-tax income of $20 million. The owner is willing to sell the company for $100 million.
“This is not only a great company, but it’s a great investment,” said Flum.
An investor could borrow the $100 million, and with interest rates at 5 or 6 percent, pay $5 million or $6 million interest, with the added attraction of a partial interest expense write-off to capture a significant return on that investment (the $20 million net income stream).
However, paying $1 billion for the same company, with $50 million in revenue and $20 million in net income. Thus, the same respective top and bottom line represent a terrible investment.
We’re in that $1-billion-for-a-$50 million-company territory across a variety of markets, said Flum, where stocks are selling at 1.3 times book value and bonds are yielding, well, very, very little.
“When I look around in the world today, if we would look at stock markets and bond markets, they are so dramatically bad investments that any little minor thing could start to throw it off and cause a crash,” he warned.
Along comes the coronavirus, which has huge implications for the global economy and where the true impact across economic and public health spheres is unknown.
Markets, he said, are as precarious as a 90-year-old individual teetering from side to side, where a marble (an unforeseen event) represents a risk of a trip, a fall, and lasting damage.
“This virus is a bad thing, and it is going to be extraordinarily disruptive,” he said. “But if markets were selling at very good, low multiples of value, then whatever the worth is, it’s not the end of the world.”
The Debt Trap
Here’s where the tottering and the dangers of collapse loom.
As he said, various corners of the economy are interrelated and intertwined throughout the world. Through the past several decades, companies and supply chains have gotten leaner, with an eye toward cutting down on lead times and inventories (thus keeping expenses and working capital requirements low).
At the same time, balance sheets have become ever more leveraged in an era of cheap debt.
In just the United States alone, according to Flum, bond debt, not counting loans, held by public companies represents 48 percent of GDP, and total debt outstanding (public and private) represents multiples of GDP.
“That’s a record,” he told PYMNTS, “and a lot of it is junky corporate debt. The quality of debt has come down over the last several years because the governments of the U.S. and around the world suppressed interest rates.”
Thus, companies with relatively poor business plans — with no profits to show for their efforts, operating in verticals with low barriers to entry and high competition — have been able to borrow.
Flum said debt is a different financial animal than trade credit. As he said, when it comes to trade credit, a dialogue takes place between buyer and supplier that can negotiate new terms and take current economic factors into account, allowing for some flexibility and breathing room. The buyer who needs a few extra days to pay may well get them.
“There are no personal relationships like that when it comes to debt,” said Flum.
Debt dictates that a company — troubled or not — make interest and principal payments as scheduled, or face the consequences, namely a default. Debt, as Flum said, exists in a world where such actions come automatically, and the debt landscape is an unforgiving one.
Of the lenders (who are in turn fueled by savers looking for rates of return), Flum said: “We want to know when lending money, this is a pure mathematical relationship. We get 6 percent interest… We’re not trying to figure out whether you have a good product to sell.”
Repayment Risks And Ripple Effects
Against that backdrop, there’s particular danger with exogenous events such as the coronavirus. Amid panic and supply chain shocks, revenues freeze, which means cash flow is negatively impacted, which means repayment risk gets ever larger.
The ripple effects also impact the people who give banks, financial funds and ETFs the money to lend to these risk companies, said Flum, which includes individuals who see the value of their holdings slip precipitously.
Those individuals will start to save money, of course. They won’t go out to buy new cars or other items, said Flum. Overcapacity is the result. Where 25 million cars may have been produced and sold, now there’s demand for only 10 million. He joked that we might have to go to Mars to find new buyers.
Too much debt and too much capacity leads to unemployment, said Flum, and trade wars are a complicating factor where tariffs have been used as a means to reduce imports while targeting exports — and likely will be used again to mitigate unemployment in individual countries.
“Currency becomes important,” he said, especially in stimulating exports that can help these same precariously balanced companies become a bit more competitive around the world.
That’s part of the reason why the U.S. Federal Reserve (and other nations’ central banks) lowered interest rates.
“What’s happening now is that everybody starts trying to influence interest rates artificially,” he added. “That’s what negative interest rates are all about.”
Negative interest rates, he said, reflect a mindset where people are frightened to the point where they don’t want to invest capital in corporations, even where they can get a higher rate. They’d rather pay a fee to a bank or adviser to lend to a safer borrower and get back 97 cents on the proverbial dollar a few years from now.
“We’re looking at an [expected] economic contraction on scale that we don’t know that that corporation is going to be able to pay the money to us in five years,” said Flum, but there’s confidence that the German or U.S. government is not going out of business.
There’s the bet, too, implicit in negative rates that a house selling for $500,000 today will be selling for $300,000 a few years from now, indicating that the purchasing power of the currency will be dramatically higher (a scenario that implies a depression).
“In all of recorded history,” Flum said, “there’s never been negative interest rates because nobody has said, ‘If you take my money, you only have to pay back 95 cents.’”
Where we tread new ground, cautioned Flum, “the first thing to do is to have a healthy disrespect for those individuals who claim to be brilliant” and know the exact path forward.