Tensions Over Junk Bond Covenants Start To Boil Over

The Fed has spoken, and so have the data have: no change. The central bank's latest statement had its usual mix of professional optimism and caution: risks are balanced, the economy "will expand at a moderate pace" and the weather gets the blame for the weak first quarter. The Fed's hoped for outcome is the market-positive one: growth will rebound in the second quarter ("growth…has picked up recently") and possibly gain some additional traction from an amorphous mix of improving labor markets, normalized weather, and "diminishing" restraint from fiscal policy.

When looked at simply, the market-positive case is based on a series of reasonable-looking assumptions - higher levels of employment will mean an increase in demand, increasing levels of capacity utilization will force businesses to increase capital spending, and the resulting combination of investment and spending growth will lift the economy to higher rates of growth. Many are so enamored of the concept of this virtuous circle that their assertions about 3%, even 4% real growth in the rest of the year (or second half, if you're the cautious sort) have remained largely untouched, even steadfast, in the face of the last two quarters of declining growth rates and the last few years of nominal growth remaining at 4% or less. After all, it stands to reason. Doesn't it?

Unfortunately, neither life nor the economy are ever quite that simple. If the assertions about employment and capacity utilization spurring ever-more demand were true, there would be no business cycle. Employment doesn't peak with the cycle, or even ahead of it, but afterwards, continuing to increase after general business conditions have started to contract, as well as decreasing after recoveries have begun. The longer development nature of capacity expansion means that it too continues to expand after the business cycle has turned.

Since the second world war, the business cycle has foundered on supply and demand imbalances. The production of goods and credit reaches excessive levels, and businesses are forced to cut back. The nature of the overproduction has changed along with the changing composition of economic production - as the US has shifted to a financial and service-based economy, the role of manufacturing has diminished and with it the more-classic problem of excessive inventories of goods.

I don't want to go too far down the road of generalizing about the economy and the business cycle - the compositional changes and their implications matter, but how much they matter and the nature of the causalities involved are not yet widely accepted or even understood. Suffice to say that the overproduction of goods still matters, but matters less than it once did, while the overproduction of credit matters more, reflecting their changing weights in the economy.

The fact that the two items, goods and credit, are running less in tandem now poses a conundrum for the Federal Reserve for which there is little direct historical comparison. By many measures, such as junk bond issuance, margin credit, leveraged loans, covenant-lite lending and even investment grade bond issuance and the central bank's own balance sheet, credit growth has already passed into an excessive stage. The tinder for a destructive fire has clearly grown, but what is not clear is how combustible it might be in the absence of industrial overproduction.

The Fed is trying to manage the issue in two ways. On the one hand, it is trying to ease out of balance-sheet growth by gradually eliminating additions (the taper) while trying out methods to trim excess reserves, such as reverse-repo operations and floating quiet trial balloons about the cessation of rolling over the maturing bonds in its portfolio. Ideally, the central bank's balance sheet would shrink "at a measured pace" over the next two or three years and converge with the end of the current business cycle. The Fed not only needs to avoid adding any more dry tinder, it also needs to restore some accommodative room on the policy side in case something should go wrong in the world: Right now the bank is largely all-in, though institutional constraints forbid it from ever saying so.

The second part of the approach is the zero-interest rate policy (ZIRP). So long as ZIRP is in place, the yield curve cannot invert, and it is likely this consideration that is now driving rate policy more than any notions of trying to funnel more credit into business. The curve can flatten, and there has been a lot of attention lately to that phenomenon and what it might mean, but it cannot invert. So long as it doesn't invert, the possibility of a financially-induced contraction, or even crash, will remain less than otherwise.

The bank cannot keep ZIRP around forever, of course. The hope is that the economy "will expand at a moderate pace," which will not only aid the Fed's employment mandate, but hopefully create upward drift in the long end of the curve, something that the taper ought to help as well by removing a source of demand. If the longer end of the curve can steepen, then in theory the Fed could edge away from ZIRP without the yield curve inverting. Even better would be if the Fed could get the middle of the curve to rise first, thereby inducing more commercial lending.

There are pitfalls to this approach, not least of which are that we don't know for certain how big they are, let alone what they are.

One of the most evident pitfalls, and one of immediate concern to the stock market, is that the Fed's policy has resulted in asset prices rising much faster than the level of economic activity. While the central bank waits for more wealth-effect spending to give an additional spur to the economy, investors piling into stocks, bonds and real estate have reduced the attraction of further investment and led to ongoing warnings on valuation from the Hussmans and Jeremy Granthams of the world. Squeezing out further gains in these areas is not only difficult, the elevated levels are a combustible mix on top of all of the extended leverage. A financial system crack-up might tip an unrobust economy into contraction. There is no law that says economic activity must first return to previous levels of strength before the current cycle can end, not after the worst recession in seventy years.

A second obstacle is that the rise in home prices has not restored homebuilding to its former vigor (apart from stock prices). It's one of the few industries left that corporate America has found itself unable to outsource, and thus a key missing ingredient in the recovery of the skilled trade labor market. While I believe that homebuilding will continue to improve on a year-on-year basis, it will not return to normalized levels of activity in the current cycle. The institutional memory of credit lenders simply doesn't work that way. Prices may have risen to pre-crash levels, but lending standards are going to remain at post-Depression levels this cycle, and could take another full cycle before easing in any significant way (the situation will not be helped if any of the age-old partisan attempts to functionally eliminate Fannie & Freddie succeed).

A third pitfall is that we don't know the limits of the current cycle's potential. The old rules of thumb about capacity utilization and employment were not of much use during the last economic cycle - the economy never reached previous high-water levels of utilization, while the labor market lost share of national product and per-capital real income stagnated. The current backdrop of unfavorable demographic trends, stagnant wage growth and record-high corporate profit margins (and share of GDP) may not translate into something we could call an "escape velocity" of economic growth this cycle.

Recent data does not yet suggest that the underlying trend of the economy has altered in any new way. The latest four-quarter rate of nominal GDP growth was 3.7%, a result that was partly checked by adverse weather. The longer-term trend of nominal growth in this cycle has been 4%, with the exception of 2013 when it fell to nearly 3% under the pressure of fiscal policy. Indeed, the backbone of the Wall Street outlook has been to start with a fresh base of 4% nominal growth, add in an overlay of expanded business capital spending and higher employment, surely good for a few tenths, and then subtract the ongoing inflation rate of about 1.2%. Presto, 3.3%-3.5% real growth in 2014, maybe even higher. Sod the weather, once it passes we're back in the game.

At this point, that stretches the limits of plausibility. Neither homebuilding nor autos are going to have the same year-on-year rates of growth in 2014, particularly the former. It's already May, and while we can expect some above-trend pickup with better weather, it isn't going to be enough to rescue the year. The year-on-year decline in mortgage-purchase applications passed 20% last week as we head into the heart of the selling season. What's more, warmer temperatures aren't going to mean a damn to lenders.

The latest year-on-year growth in real disposable personal income was 2.2% through the end of the first quarter. That's exactly in line with the average of the previous two years. The annualized two-year rate of growth in business capital spending edged below 2.4% in March, the lowest in nearly three years. GDP appears set to finish the first quarter with a negative number after revision. Yes, yes, the weather, but to claim that severe a falling off is an innocent slip in an otherwise robustly accelerating economy is simply to have one's head in the sand.

The elimination of over a million people from long-term unemployment benefits in the first quarter lines up closely with the near-million drop in the labor force recorded in the April jobs report. Last year's increase in the payroll tax got considerable attention from Wall Street strategists as a temporary phenomenon; this year's silence on the loss of a regular income for a million people has been remarkable.

Through the first four months of 2013, the establishment survey reports a net unadjusted loss of 27,000 jobs (the payroll count shrinks by roughly 2% in January, then resets over the following months). The current estimate for the first four months of 2014 is a gain of 22,000 jobs, a minute measurement difference (about 0.38%) in a labor force of 130 million. It really screams that there is no change at all in labor force growth, and I would add that the April number is currently at risk: unusually favorable experience in weekly claims data during the April measurement period has reversed since that time. It could well reverse again, but if the lower claims rate was simply a fluke result of lower winter hires, as I suspect, a return to trend, however modest, may have an unfavorable impact on data later this spring.

Putting aside our sentiments about what we would like the economy to do, the strongest conclusion I can reach from studying the underlying economic trends is that like the Fed, they have not changed. What's more, it's becoming increasingly difficult to escape the unwelcome, yet intuitively sensible conclusion that the Great Recession is being followed by a cycle of economic growth with a lower bound than what historical averaging might suggest - much like the recession itself. To put it another way, the "New Normal" is still alive and well.

Yet there is nothing to stop the media from claiming that the first-quarter fall-off was some bizarre freak of the weather, while the weather-related rebound is something of a much deeper significance. Certainly not any sense of shame. That 6.3% unemployment rate, however flawed, is going to find far more play and staying power on the front pages and in drive-time news reports than any waffling about the lowest participation rate (62.8%) in over thirty-five years, or the virtually total lack of earnings power.

Certain realities do remain, though, and will loom higher as we get deeper into spring. Valuations remain very extended, the Fed is still moving from a policy of more accommodation to less, the yield curve cannot invert, and the underlying economic trends haven't changed. That will keep the Fed's taper on course and the odds of imminent recession this year vanishingly low (I would say only a systemic shock could do the trick this year), but undermine the runaway growth case at the same time.

We are also coming into a much more vulnerable part of the calendar for stocks in a market that has signaled no little amount of skittishness this year with its dumping of high-multiple issues. If you're tempted to scoff at why something like the calendar alone should pose a threat to the stock market, then consider that corporate earnings growth in the first quarter is currently estimated to be negative in real terms and only 0.2% in nominal terms. Not everyone may want to continue to believe that that merits equity indices being at all-time highs. There is still a little upside seasonal potential left at current prices, especially if tensions in the Ukraine should ease (I have no guess on that other than to say it's a pure guess), but I'd be very, very careful about trying to squeeze it out.

And wish the Fed luck.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tensions Over Junk Bond Covenants Start To Boil Over


Tensions Over Junk Bond Covenants Start To Boil Over