Quantity Theory and Bezzle
I have almost every finance/economic/wall street related app stored on my mobile device, and the reason is as personal as it is professional; I am personally vested in everything that culminates in the capital markets, the omnipresent forces of supply and demand and their impact, both positive and negative, and lastly, having updated information on the aforementioned helps me perform well at my job. The amount of notifications that I have gotten from all the applications is staggering to say the least. Notifications have been about everything from interest rates, fixed income, bond yields, to troubles in the real estate lending market and transactional activity. Rummaging through the articles and reading pundits' thoughts and ideas on the economy made me think of two integral concepts, or at least I think they are important, that seem to have been lost to economic and financial history as well as investors' collective conscience: Quantity Theory and Bezzle.
Milton Friedman once quoted, "Time delay between changes in the quantity of money and in other magnitudes are 'long and variable' and depend a great deal on surrounding circumstances." We seem to have either forgotten or do not give as much credence to the relationship between money, nominal income, and real income growth as we should. Yes, the FED has stopped hiking for now, forgive me if you are in the "they will hike once or twice more camp," but I am wary of the economic consequences that we have yet to witness due to the instantaneous hiking that Powell and Co. have already done. There is deluge of information on economic studies that have conveyed the aforementioned relationship with great eloquence, and so my purpose here is not to regurgitate the studies, but rather to summarize the results, and hopefully I will be able to properly demarcate the said relationship. The studies have concluded that there is a one to one relationship between the growth of money and the nominal income and inflation within an economy. When the government- through fiscal or monetary policies- increases the growth of money, it leads to inflation and thus higher nominal income, albeit in the long run, i.e., 12-18 months- this is the lagging affect you might have heard professionals and pundits use throughout various financial interviews recently. For instance, think about the easy money policy the FED enacted for more than a decade after the great recession and what that growth led to. Additionally, growth in money leads to a lower proportional decrease in real income. Economic studies have concluded that growth in money might even lead to negative real income.
On to the second concept known as bezzle. It is an economic term coined by John Kenneth Galbraith back in the day and addresses issues circumnavigating wealth that people seem to think they have, but lack in reality. Galbraith further noted that bezzle is abundant during exuberant times, and narrows during recessions. For instance, think about the lofty and sky high valuations, market performance due to positive news and expectations, and humongous increase in pricing for nearly every asset. The concept entails that even though the investors/owners thought they had access to all of this accumulated wealth, factually they were setting themselves up for a heart wrecking. An easy way to think about this is just to pick an equity, any of the FAANGs or another stock, and look at the gargantuan valuations and as a result insane and unsustainable stock prices, and consequently, higher market caps. What happened at the beginning of Covid-19? Anyone care to venture a guess? You guessed it, valuations plummeted, cash flows got riskier, and cost of debt started to inch up, and all of this, among other factors, led to a drop not just in stocks but entire indices. All of a sudden, wealth that people thought that they had, vanished overnight. This is called bezzle.
Higher for Longer
Now that we have these two important concepts out of the way, lets address the current state of affairs.
The economy has proven remarkably resistant, and other facets such as the unemployment rate and consumer spending have so far remained steadfast, but there is a reckoning to come. Higher rates have taken a more concrete position, and the higher cost of debt will soon creep up on companies and firms from across all industries. The only immune companies will be the ones with healthy cash reserves; companies with healthy cash cushions are raising capital despite of the higher rates, think of the Pfizers, Apples, and Googles of the world. But companies with below investment grade ratings, also known as high yield and junk, could face their Everests in the coming months. Companies issued gigantic amount of debt, all thanks to FED's quantitative easing, and a huge chunk of that debt is due in '24, '25, and '26. Debt issued pre-Covid had a cost of debt ranging anywhere from a 100 basis points to 300 basis points, but the refinancing of that debt, or pushing maturities into the future will entail taking on debt but with much higher interest rates which is simply unsustainable for most capital structures. A day before this post, I read about WeWork not being able to make interest payments and are looking to attain favorable terms from their lenders. We will be reading an abundant amount of articles regarding companies' failure to meet their obligations in the near future.
Couple higher rates and cost of debt with potential revenue losses and you have a recipe for disaster. Companies will see their EPS shrink due to a smaller numerator, one of the ways to rectify this loss in wealth is to reduce the number of shares through buybacks or reverse splits, both of which could prove grueling given the current circumstances. Lower EPS will lead to a fall in stock prices which will ultimately push their cost of doing business even higher; suppliers and other business partners will begin asking for upfront payments rather than deferred, and managements will have to comply. These are just some of the issues awaiting companies in the near future, and I am certain there will be tougher decisions to be made down the line.
Higher for longer narrative, it seems, has finally caught roots as companies are beginning to borrow despite of the sky rocketing cost. According to Bloomberg, September was one of the highest months in terms of raising corporate debt, to the tune of more than a $100 Billion. As stated prior, companies have debt that is maturing in the next couple of years and companies tend to raise more debt to repay or retire their old debt at least 18 months before the maturity; this allows the companies to prevent the upcoming maturities from appearing in their financial audits. C-Suite and executives have made their peace with the reality of higher rates for longer, and are compelled, partially by nature and partially nurture, to raise more debt in this environment. The hope is that they will proceed with bearing the brunt for a couple of years and when the rates do decline in the future, they will be able to retire higher rate with lower rate debt.
Higher rates aren't all bad news. There are sectors of the economy that have picked up pace and are likely to grow in the current macro trends; namely the private credit industry. After the fall of Credit Suisse and SVB, traditional banks have lately been hesitant to underwrite more loans due to high interest rates and consequently higher chances of borrowers' defaulting or missing payments. This is where private credit has stepped up its game and hedge funds, private equity funds, and other alternative asset managers have begun to underwrite one jumbo loan after another. These private institutions get a great leeway in determining their returns due to the vary nature of their existence: private credit and loans are done behind closed doors, and do not require registration with the SEC. This allows the private credit managers to charge higher rates and even demand some sort of an equity kicker at the end. I will foreshadow, though, that this will not persist for long; mainly because banks have picked up the scent and have restarted conducting transactions, but also because the private credit- albeit is roughly around $1.5 Trillion- market will become more saturated as more institutions and banks enter the space. Private credit of course comes at a higher price tag for the borrowers, but companies- in current environment- do not have the number of avenues they used to just a couple of years ago. Private credit market, as a result, has been able to provide returns higher than some of the other segments of the investment world. Although the private credit market seems enticing, it does have its short comings. The biggest drawback is the fact that these loans are made behind closed doors and therefore do not require SEC registration, it is hard for anyone to quantify the risks involved and the bubble building that could end up hurting the larger economy. Regulators understand the thirst within this particular field and have begun to consider changing rules and regulations to enhance transparency and protect investors' interests. It remains to be seen what those will be and what their affects will be on the PC market as well as on other segments of the economy.
Finally, I would be remiss if I didn't mention real estate lending and the whirlwind of a ride that its having. To take a trip down memory lane, after the recession of 2007-08, big banks suppressed making real estate loans and left a vacuum that regional and community banks were more than happy to fill. Fast forward to today, banks are exposed to roughly $3 Trillion in real estate loans and cracks have started to appear. Contractors and developers are either defaulting on loans, or are not as passionate about the industry as they were between 2015-21. Some of the developers have even begun to surrender their collateral or the buildings to the banks; this, of course, presents another issue for the banks which is that yes, they have their collateral and buildings, but the only way to get their funds back is to liquidate those holdings, and that is where the wrinkle is. Do you know anyone who willing to buy a building worth $50M in these market conditions? $75M? or a $100M? Ergo, regional and community banks are forced to not only write off those loans but also hold on to these tangible assets till an appropriate time to sell.
In conclusion, no one knows what the future holds. All of the understood and accepted metrics of measuring financial markets' success, bonds and equity performances, and various other macro and micro trends are in smithereens. I am not sure if I am echoing the generally accepted commentary by saying this, but I believe we have to wait and watch. One thing is for certain, portfolio managers and investors have their work cut out for them.
