Be afraid: the zombie economy can’t last

Christopher Joye

Coolabah Capital

In the AFR I write that the contradictory cocktail of extremely high inflation, zero interest rates, tight labour markets, robust wages growth, elevated inflation expectations, and record asset prices should have you worried. But the party may not be over just yet…

As the comparatively more benign Omicron variant of the virus reinforces the new normal of coexisting with the disease, and sluggish central banks get further behind the curve, this bull market could elongate for some time.

That’s what we saw in 2016 when the US Federal Reserve commenced a hiking cycle, lifting its cash rate from near-zero to above 2 per cent by late 2018. In 2016 and 2017 equities and credit spreads both rallied. It was not until the latter stages of this tightening process, when the Fed’s cash rate rose materially above 1 per cent and the 10-year government bond yield pierced 2.5 per cent, that credit and equities turned.

Current conditions are, however, different because of the absence of an inflation shock between 2016 and 2018. To better understand the downside risks, it’s worth considering the deep disconnects in both the data and monetary policy settings.

The cyclically-adjusted Shiller price/earnings ratio for the S&P500 is currently at its second-highest level (39 times) in the last 140 years, surpassed only by the 2000 tech boom when it hit 44 times. Note that peak was quickly followed by a 50 per cent drop in US shares over the next two years.

Given the apparent relationship between extreme deviations in the Shiller price/earnings ratio and sharp subsequent draw-downs, investors should have pause. Based on the average level of this benchmark over the last 20 years, the US equities market looks 40 per cent overvalued.

Following the “tech wreck”, the Fed quickly reacted via the infamous “Greenspan put”, slashing its cash rate from 6.5 per cent (!) all the way down to 1 per cent by 2003. The Fed could provide this support because core inflation was benign and sitting around its 2 per cent target.

Since 2000 there has been a correlation between rising equity valuations and declining long-term interest rates, which makes sense given the latter are the discount rates used to price the present value of a company’s future cash-flows.

The currently very low US 10-year government bond yield of 1.5 per cent, which is a key discount rate proxy, is less than half its average level since 2000, and a full 100 basis points below the Fed’s 2.5 per cent estimate of its so-called “neutral” cash rate. This is the interest rate the Fed would maintain if inflation was bobbing around its target and the labour market was fully employed. It is conspicuously much lower than the interest rates required to bring a bona-fide inflation outbreak back to earth.

This is where the financial market outlook gets gnarly. There is an unprecedented divide between the current US inflation pulse and the monetary policy settings of the world’s most important central bank. The Fed’s preferred measure of core inflation is running at 4.8 per cent on a six month annualised basis or 4.1 per cent year-on-year, which is the highest level recorded since the early 1990s (and double the Fed’s target).

To make matters worse, burgeoning price pressures are impacting the way households think about their future with consumer inflation expectations rising to between 4-6 per cent, the loftiest levels since the early 1990s.

The transitory inflation thesis attributed these price spikes to supply-side blockages precipitated by the pandemic, which was undoubtedly a driver of the first-round effects. Unfortunately, there is evidence that a wage-price spiral may be developing.

The world’s largest economy is recording the briskest wage growth since the early 2000s. On a six month annualised basis, US wages have expanded at a 4.1 per cent pace. Combined with a very low jobless rate of just 4.2 per cent (close to estimates of full employment), expectations of a higher cost of living may be fuelling more assertive wage claims, which workers can make as the balance of power shifts from employers to employees.

Since the GFC, we’ve argued that continuously trying to mitigate all economic woes by running zero interest rate policies coupled with never-ending money printing that funds unsustainable fiscal stimulus will ultimately end in an inflation crisis.

Policymakers have got into the habit of thinking they can disintermediate markets with their own unilateral price settings by having central banks buy trillions of dollars worth of privately traded assets. By bidding up these prices, the monetary policy mavens reduce the cost of both debt and equity capital to levels that participants have never previously seen. Hence the sub-2 per cent home loan rates Aussie households have recently benefited from.

There is, of course, a role for all these tools when we get genuine market failures driven by exogeneous shocks. The pandemic was the best possible example of this type of external event. But once the shock passes, the world should normalise.

Instead, governments seem hell-bent on trying to disappear the business cycle even when some of its volatility is an inherently endogenous part of a capitalist system that tries to punish bad businesses and encourage more productive firms to rise-up in their stead.

The GFC was one such internal shock resulting from a misallocation of labour and capital driven by the artificially cheap money that flowed from Greenspan’s put. It warranted "creative destruction" in the form of overly levered businesses failing and their capital and labour shifting to more viable concerns. But many were kept on life support.

The moral hazard of having central banks and treasuries constantly bail-out bad businesses since 2007 has led to the rise of “zombie firms” that have earnings that cannot cover the interest repayments on their debts. In the US, around 15-20 per cent of all listed businesses now meet this definition.

Crucially, the post-GFC policy reflex of pouring public money on all private problems only works for as long as there is no inflationary cost. While that was true of the last decade, it is no longer true today, which is what makes this cycle different.

For the first time in a long time, we may face an unavoidable inflation-induced reckoning. To re-anchor inflation and consumer expectations, central banks may have to lift interest rates well-above their neutral levels. Much higher discount rates may in turn compel a savage downward rerating of asset prices.

Two simple examples illustrate the lurking risks. Aussie house prices have appreciated more than 30 per cent since mid 2019 simply because mortgage rates declined by 100-125 basis points. If mortgage rates return to their mid 2019 marks, one should expect house prices to do likewise.

Along similar lines, the US equity market is 27 per cent higher than its pre-COVID levels. While it made sense for companies to recover the price falls they suffered in March 2020, the stunning increase in valuations beyond the prior peak must be at least partly attributable to the extreme fiscal and monetary policy stimulus that firms have profited from despite fully employed labour markets and above-target inflation.

There is further downside if one then bakes-in higher discount rates. The S&P500 was, for example, some 50 per cent below its current level the last time the US 10-year government bond yield traded above 3 per cent in late 2018.

Geo-politics, long neglected by markets, may also come into play. The machine learning models we developed to predict the probability of major power war using hundreds of years of data handicap the chance of a US-China conflict at almost 50 per cent. If I were President Xi, I would take Taiwan while the insipid President Biden is in power. If he delays, he may have to face a second Trump term, which would raise the stakes of a truly existential military crisis. And if I were President Putin, I would retake eastern Ukraine at the same time as Xi unifies Taiwan so as to splinter the Western allies.

One mitigant is that the global economy is now so drunk on cheap money, and so heavily indebted, that central banks may not have to lift rates far to crush inflation. This implies that the neutral cash rates may be lower than they have been in the past. But 100 basis points of mortgage rate hikes will still drop Aussie house prices by 15-25 per cent. And some sort of mean-reversion in discount rates should similarly push global equity valuations down.

When all this comes to pass is an open question. If history is any guide, there may be further asset price appreciation until markets are convinced interest rates are heading into genuinely restrictive territory. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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