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Barely Hidden Threats. Part 2

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NEW YORK – December 5, 2018

Part I: https://usareally.com/2210-barely-hidden-threats-part-1

The soft policies of the Fed in the past have led to the breeding of "zombie companies" in recent years, as economists used to call organizations that are unprofitable or have income too low to live by without serious borrowing.

A study by the Bank for International Settlements (BIS, the international financial organization, and the official forum of Central Banks) states that "the profits of such companies did not cover their debt-servicing costs even at post-crisis ultra-low interest rates." In fact, zombie companies are able to somehow live only in conditions of super-cheap lending. The BIS estimates that the share of such companies in OECD countries reaches 12%. That's too much.

According to analysts from the Xerion Investments, by the summer of 2018, more than a third of the world's largest companies had a high level of debt, that is, they had at least five dollars of debt for every dollar in profit, and that makes them vulnerable to any decline in profits or increase in interest rates. And one of the five companies has debt service obligations that already exceed cash flow.

Despite Donald Trump's statements that the Fed has "gone crazy," it is clear that the policy of tightening will continue. Debt service will become more expensive, and it looks like the first American "zombie" is about to crash. Some believe that it will be the symbolic death of General Electric, whose capitalization has already fallen to $65.93 billion, falling from the peak of 2000 to 87%. The bankruptcy of the oldest industrial conglomerate of the US could launch a collapse in the stock market (in the third quarter of this year, GE reported losses of $23 billion). And this is with negative net assets, corporate debt of $114 billion and a ratio of net debt to EBITDA of 17!

Such companies have been dubbed "BBB-companies." They have a credit rating of the latest investment grade plus debt problems like GE. They include other representatives of the real sector — for example, Ford ($158.33 billion in debts, with a ratio of net debt to EBITDA — 9.3).

But it is much more interesting that among the companies of the new economy there are also credited giants. For example, Netflix: revenue of $15 billion, debt of $8.34 billion, but the ratio of net debt to EBITDA is more than three and in addition it has a a negative operating cash flow. Or the ill-fated Tesla: net debt to EBITDA ratio greater than 16(!) plus losses.

Now let's talk a bit about the unemployment rate.

The low unemployment rate is perceived by society as a positive sign, as in this case it is assumed that anyone who is willing to work will have a job. Coupled with the fact that wage growth in the US accelerated to a nine-year high in October (3.1% year-on-year versus 2.8% in September), the country seems to be doing just fine. However, American experts have so far been slow to celebrate. There is a reason for such low official unemployment, and it is not so positive.

The fact is that in the US unemployment statistics, the labor force consists of those who are already working, and those who are looking for work in the last month. This means that a low figure may mean that either more people have found a job or more people have stopped searching. And it seems that the ultra-low unemployment in the US is now due to the second scenario.

So, if you look at the employment chart (graph 3), you can see that fewer and fewer people are actively working or looking for work. In addition, low unemployment in the US in general often becomes a harbinger of problems. Thus, low unemployment in the late 1960-ies preceded a sharp rise in inflation in the 1970s; in the late 1990s, the technology bubble burst (the so-called collapse of the dot-com). In the mid-2000s, the real estate bubble burst, followed by the financial crisis.

Meanwhile, the debts of American households continue to grow rapidly. The total amount of US household debt for the third quarter of 2018 increased by 1.6%, or $219 billion, amounting to a record $13.5 trillion, according to the report of the Federal Reserve Bank (FRB) of New York. Americans’ debt exceeds the pre-crisis level and has been growing for 17 consecutive quarters due to an increase in mortgage lending. 

Barely Hidden Threats. Part 2

However, in relative terms, all is not so bad — during the last crisis, household debts exceeded 86% of US GDP, and now they are at 70%. But at what point the debt burden on consumers will become exorbitant is unknown.

The financial market is already experiencing profound changes. The US debt market resembles a weather vane — it clearly shows the mood of the market. The trade war between the US and China (and at the same time the Fed's rate hike) led to a decrease in the cost of US Treasures and, accordingly, to an increase in their profitability. It should be noted that as part of the economic confrontation, China dropped US Treasures. This also had a significant impact on the market. This has already led to a clearly visible convergence on the yield chart of short and long US debts. It is obvious that, according to investors, the risks in the short term are significantly higher than in the long term.

This, by the way, led to a rather interesting effect: at some point, the yield of US one-year bonds was higher than the yield of a similar national debt of China. That sounds bad for China.

However, some experts do not consider the convergence of US and Chinese debt yields to be a long-term trend, but rather a "flight to quality" from high-yield Chinese bonds. But the problem is that investors have nowhere to run — there is the dominance of garbage and junk bonds in the US bond market. The US stock market raises concerns too. The leverage on the NYSE has recently become extremely high, and in any serious shocks it will lead to the shaft of margin-call. Fearing this, banks already “withdrew money.” In this case, shifting occurs primarily from high-tech, finance and real estate. The market instinctively feels the most subtle places that are about to break.

Obviously, any decline or slowdown in growth should not be called a crisis, but the emerging picture says that it is on the way.

Author: USA Really