Will Corporate Debt Cause the Next Recession?

One thing is certain: A U.S. recession will eventually come along. The question is what will cause it and when. Among the oft-discussed culprits is corporate debt. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate whether companies have accumulated too much debt and if that poses a risk to the economy.

Noah Smith: More people are worrying about U.S. nonfinancial corporate debt, which is at an all-time high as a share of the economy. Bloomberg News looked into a bunch of big acquisitions and found that a lot of companies are so leveraged that they would have a junk label if credit raters weren’t being lenient (sound familiar?). The Federal Reserve is starting to watch the leveraged loan market carefully as these loans proliferate. Bank of America is on “recession watch,” modeling losses from a junk-bond crash. Bloomberg Opinion’s own Danielle DiMartino Booth believes that large amounts of so-called investment grade debt isn’t actually very safe, consisting of leveraged loans, junk bonds and BBB-rated bonds. Meanwhile, credit spreads have shrunk to levels that often presage a recession. And the Fed intends to continue raising interest rates.

Why shouldn’t we be worried about corporate debt?

Nir Kaissar: I don’t see much in companies’ financial statements to be alarmed about. For one thing, they don’t seem excessively levered. The Standard & Poor’s 500 Index represents roughly 80 percent of U.S. public companies by market value. Its debt-to-equity ratio is 113 percent. That’s lower than the average of 163 percent since 1990, and half as much as during the past two market peaks in 1999 and 2007.

Of course, some of that is related to deleveraging by banks since the 2008 financial crisis. The D/E ratio of the S&P 500 Financials Index is 158 percent, down from 563 percent in 2007 and 585 percent in 1999. But the numbers are no more concerning after excluding the banks. The D/E ratio of the S&P 500 Ex-Financials Index has climbed to a relatively modest 93 percent from 75 percent in 2007 and a post-crisis low of 68 percent in 2010.

Those numbers don’t suggest excessive demands on companies’ ability to pay their debts. The S&P 500’s EBIT margin — or earnings before interest and taxes as a percentage of sales — is 13.3 percent, which leaves lots of room for companies to absorb higher interest rates at current leverage levels. Yes, EBIT margins will contract during the next downturn, but interest rates would most likely decline, too.

There are things to worry about, but excessive corporate debt doesn’t appear to be one of them.

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Yale Champions Social Investing (Whatever That Is)

Socially responsible investing just received a big endorsement, but what it really needs is some clarity.

Yale University announced last week that its endowment might exit private investments it deems unethical, extending a policy it has long applied to investments in public markets. In fact, the university counts itself among SRI’s pioneers. Its ethical investment policy declares that “Yale was one of the first institutions to address formally the ethical responsibilities of institutional investors.”

Given the influence of Yale’s $29.4 billion endowment — second in size only to Harvard University’s $39.2 billion trove — the announcement will undoubtedly raise SRI’s profile. But SRI and the broader sustainable investing industry have never lacked attention. As my Bloomberg colleague Eric Balchunas recently pointed out, sustainable investing enjoys “to-die-for PR that eludes most categories.”

That attention hasn’t yet translated into investment, however, at least as judged by flows to exchange-traded funds. Just $6.6 billion of the $3.5 trillion in ETFs, or 0.2 percent, is invested in the category. Balchunas offers fund providers some sensible tips for sparking more interest, including lowering fees, choosing snazzier names, offering more concentrated portfolios and preaching to a broader audience.

But the industry has a more fundamental problem: Investors are lost among the various styles in the sustainable investing zoo. If the industry wants to attract investors, it must first explain what it has to offer.    

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Pension Funds Should Think Twice About Alternatives

High-performing alternative investments are great if you can find them, but pension plans shouldn’t count on it.

The Pew Charitable Trusts recently published its latest report on the investment practices and performance of the 73 largest state public pension funds as of the 2016 fiscal year. The big development is that pension funds are moving their money from stocks to alternatives such as private assets and hedge funds. The average allocation to alternatives more than doubled to 26 percent in 2016 from 11 percent a decade earlier, with a roughly equal percentage leaving stocks.

In an accompanying blog post, Pew warned that the move to alternatives would result in more volatility and higher fees for pension funds. Writing for Bloomberg Opinion, investor Aaron Brown took the opposite view last week, arguing that alternatives dampen volatility and boost performance, even after accounting for fees.

Neither view is entirely right. And with an estimated $1 trillion in state and local public pension funds invested in alternatives, and the retirement of 19 million current and former state and local employees at stake, decision makers rushing into alternatives should be clear about what they’re buying.

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Hedge Fund Stars Crying Uncle Gives Industry Hope

The hedge fund industry is losing its star managers but gaining an opportunity to rebuild its battered reputation.

Bloomberg News reported last week that Jon Jacobson, investor and founder of Highfields Capital Management, is winding down his $12.1 billion hedge fund after two decades. As the article noted, he joins a growing list of elite managers who have left the industry or plan to, including Richard Perry, Eric Mindich, John Griffin, Neil Chriss and Leon Cooperman.    

In a letter announcing his decision, Jacobson bemoaned a “very treacherous investment environment.” That’s no exaggeration.  

A combination of lethal forces has hit hedge funds in recent years. One is a raging U.S. bull market. Jacobson’s fund has been flat since 2017, while the S&P 500 Index was up 35 percent over that time through September, including dividends.

Granted, an investment in hedge funds isn’t the same as buying the broad stock market. But as I noted recently, that doesn’t stop many U.S. investors from comparing every investment with the S&P 500. And by that yardstick, few investments measure up over the last decade. Foreign stocks, bonds, private equity, venture capital, real estate and, yes, hedge funds have all lagged.

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Investors Are Supposed to Be Rewarded for Risk, Right?

After the Federal Reserve raised the federal funds rate as expected on Wednesday, investors are no doubt watching how longer-term interest rates respond. But the stock market’s moves will be just as revealing.  

U.S. stocks have been on a historic run since the 2008 financial crisis. The S&P 500 Index has returned 18 percent annually from March 2009 through August, including dividends, making it one of the best decades for stocks since 1926. It’s also the second-longest stretch without a bear market, as defined by a decline of 20 percent or more.

Bulls attribute much of that success to lower interest rates. It’s no coincidence that stocks skyrocketed soon after the Fed dropped rates in late 2008 in response to the financial crisis, they argue, and that the market kept moving higher while the Fed held rates low for years.  

The gist of the argument is that investors expect a premium for owning risky stocks rather than safe bonds — in technical jargon, an equity risk premium. When bond yields decline, stocks can pay less, too, provided that the premium stays roughly the same. But there’s little evidence investors are paying attention to the premium.

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When Pot Smoke Clears, Profits May Be in Familiar Hands

Investors may be betting on marijuana in all the wrong places.

Enthusiasm for pot stocks reached a fever pitch last week when investors piled into British Columbia-based Tilray Inc., a developer of cannabis medicinal products, doubling its stock price over three trading days through Wednesday. Volume for Tilray’s stock had averaged 7 million shares a day since it went public on July 18. Last week, that average spiked to 20 million.

Investors were already plenty high on pot stocks before Tilray came along. Three of the biggest by market value, Toronto-based Cronos Group Inc., Vancouver-based Aurora Cannabis Inc. and Ontario-based Canopy Growth Corp., are hugely expensive. None are profitable, but their average price-to-sales ratio based on expected revenue for the 2018 fiscal year is a stunning 185, or 50 times that of the S&P 500 Growth Index’s P/S ratio of 3.6.

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A Bull Market Quandary: Your Clients or Your Convictions

The U.S. stock market is dominating again this year, and money managers may soon face some unpalatable choices.  

It’s not even close. The S&P 500 Index is up 9.9 percent in the eight months through August, including dividends. Meanwhile, overseas stocks, as measuredby the MSCI ACWI ex-USA Index, are down 3.2 percent. U.S. bonds, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, are down 1 percent. And hedge funds, as tracked by the HFRI Fund Weighted Composite Index, are up a modest 1.7 percent.

It’s too soon to know how private assets, such as venture capital, private equity and real estate, have done because their results are generally reported on a multi-month lag. But it’s not likely to matter. Even the most ardent admirers of private assets, such as elite university endowments, allocate only a portion of their portfolios to them. So the results, however good, are unlikely to make up for the drag from other assets.

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Value Versus Growth Plays Out in Emerging Markets

Emerging markets are flashing warning signs, but don’t tell that to value stocks.

The MSCI Emerging Markets Index is down 19.2 percent from its recent high on Jan. 26 through Friday as investors wring their hands over tariffs, slow growth, a rising dollar and numerous other fears.

To some investors’ surprise, value stocks are holding up better than growth. The MSCI Emerging Markets Value Index is down 18.3 percent, while the MSCI Emerging Markets Growth Index is down 20.1 percent.

In theory, that’s not supposed to happen. Value stocks, after all, are cheaper than growth for a reason: They represent companies, and sometimes whole sectors, that have fallen on hard times or are struggling to grow — think banks and brick-and-mortar retailers. Those problems are compounded in a downturn. And as goes the business, so goes the stock.

But in reality, stocks haven’t always followed that playbook, at least in the U.S. I counted 13 U.S. bear markets since 1926, as defined by a decline of 20 percent or more in the S&P 500 Index for the longest period for which numbers are available. I’m also counting the periods from September 1929 to March 1935 and from March 1937 to April 1942 as a total of two bear markets.

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Who Lost the Most in the Financial Crisis? Ordinary Americans.

Bloomberg Opinion marks the 10th anniversary of Lehman’s bankruptcy with a collection of columns from around the world. Read more.

A decade after the collapse of Lehman Brothers Holdings Inc., there are still arguments about who was responsible for the 2008 financial crisis. But it’s also worth revisiting who paid for the crisis and who profited from it.

Any discussion about winners and losers, of course, must start with the bank bailouts. The centerpiece of that rescue was the Troubled Asset Relief Program, or TARP, an October 2008 federal law that authorized the U.S. government to “invest” in banks and their toxic mortgage-related assets. The U.S. Treasury invested $426 billion and ultimately recovered $441 billion when TARP ended in December 2014.

While it’s true that TARP turned a profit, the reward was laughably inadequate for the risk. The program bought assets that were deeply distressed — assets that ought to pay above-market returns when prices recover. Instead, TARP generated a return of less than 1 percent a year from October 2008 to 2014, while the S&P 500 Financials Index returned 5.3 percent and the S&P 500 Index returned 12 percent, including dividends. The difference amounts to hundreds of billions of dollars.

The Federal Reserve threw banks a lifeline, too, by holding interest rates near zero for years. The average effective federal funds rate dropped to 0.16 percent in December 2008 and remained below 0.25 percent through the end of 2015. That allowed banks to borrow money cheaply. It also sapped savers of badly needed income.

Those moves were undoubtedly necessary to keep the financial system and the larger economy from collapsing. But banks bore too little of the burden, and it’s difficult to view the bailouts as anything other than a massive wealth transfer from ordinary Americans to financial firms.

But there was another — arguably bigger — wealth transfer during the financial crisis between ordinary investors and more sophisticated ones. As the stock market tumbled from November 2007 to February 2009, retail investors pulled a net $152 billion from U.S. stock mutual funds, according to data compiled by Morningstar, including adviser and retirement share classes. More than half of those redemptions, or $78 billion, were during the market’s lowest points from September 2008 to February 2009.

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It’s Not Time to Hit the Ejector Seat on Emerging Markets

This is no time to panic about emerging markets.

Imagine you hadn’t read the headlines about emerging markets this week. You didn’t know that South Africa slipped into a recession, or that the currencies of Turkey, Argentina and Indonesia are near record lows, or that seemingly every emerging-market analyst predicts that the trouble will spread to other developing countries.

Instead, all you would have are the numbers showing how emerging-market stocks have behaved in the past. You would see that the MSCI Emerging Markets Index returned 8 percent annually in dollars since 1988 through August, excluding dividends, and that the volatility, as measured by annualized standard deviation, was 23 percent during the period.

You would quickly deduce that emerging-market stocks are a wild ride. The EM index can be expected to decline more than 40 percent of the time and enter bear market territory — a decline of 20 percent or more — close to a third of the time. You would then notice that the EM index has fallen by 19.7 percent in dollars from its peak on Jan. 26 through Wednesday and most likely conclude that nothing unusual was happening.

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