We recently penned an article discussing the “moral hazard” fostered by the Fed’s ongoing monetary interventions. However, this story is fraught with zombies and the path to “Japanification.”
The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles. They are also aware that most policy tools are likely ineffective at mitigating financial risks in the future. Such leaves them being dependent on expanding their balance sheet as their primary weapon.
Such was a point they made last year, which bypassed overly bullish investors.
“… several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances-including overvaluation and excessive indebtedness-could amplify an adverse shock to the economy …”
“… many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks…”
That was in January 2020. Just a couple of short months later, markets were in the worst drawdown since the “Great Depression.”
With Central Bank interventions, it is not what is “seen” that is important, but what isn’t.
We “see” the trillions of dollars of liquidity having positive effects on asset markets.
However, what most overlook is what is happening elsewhere in the economy.
We previously discussed how the Fed’s interventions made the top 10% wealthier while bypassing the bottom 90% of income earners.
But the more insidious effect has been the rise of “zombie” companies. These companies survive only due to the Fed’s suppression of interest rates and creating a speculative investment climate for bond issuance. As discussed in “Recessions Are A Good Thing:”
“‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing.
Such is a macroeconomic problem. Zombie firms are less productive, and their existence lowers investment in, and employment at, more productive firms. In short, a side effect of central banks keeping rates low for a long time is it keeps unproductive firms alive. Ultimately, that lowers the long-run growth rate of the economy.” – Axios
Such also explains why there are currently record levels of “junk bond” issuance in the market.
The opportunistic high-yield sector did not go calmly into year-end, as raucous December issuance ($29.5 billion) shattered yet another long-standing record for the month ($27.6 billion, in December 2012), and propelled issuance for the last three months to the highest total ever for a fourth-quarter period. And this was no swan song for the primary market, as participants see the strong finish to 2020 as a lead-in to another hectic year ahead, as festering economic uncertainty and low borrowing costs stoke incentives to deepen liquidity and push out debt-maturity profiles.” – S&P
Zombies Consume the Living
While “zombies” roam the earth in record numbers, the unseen cost to the economy goes unnoticed.
These companies, borrow “living” capital from investors to feed a “dying” host. In turn, such deprive new ventures of needed capital, resources, and opportunities. Keeping dying companies alive longer than “Darwinism” would naturally allow ultimately suppresses economic growth.
The New York Fed recently had a study on how “zombie credit” has affected inflation, a byproduct of economic growth, in Europe.
“Europe’s economic growth and inflation have remained depressed, consistently undershooting projections. In a striking resemblance to Japan’s “lost decades,” the European economy has been recently characterized by persistently low-interest rates and the provision of cheap bank credit to impaired firms, or “zombie credit.”
While this study applies to Europe, we see the same effect in the U.S. Over the last decade, as zombie companies have risen to a record level in the U.S., inflation remains suppressed and well below targeted levels.
While economists continue to maintain perennial hopes of strong economic growth and inflation, such continues to remain elusive and a function of displaced capital. To this point, Daniel LaCalle noted, the displacement of capital specifically as a cause of disappointing economic growth in 2021.
With $26 trillion injected by central banks, massive liquidity injections got used mostly to perpetuate elevated government spending, fundamentally current spending, and fund public debt.
The second is that corporate balance sheets have become damaged to a level that will make it difficult to see significant investment growth above depreciation. SP Global expects global capital expenditures to remain weak in 2021.
Can’t Cure A Debt Problem with More Debt
For the last 40 years, each Administration and the Federal Reserve have continued to operate under Keynesian monetary and fiscal policies believing the model worked. However, most of the aggregate economic growth gets financed by deficit spending, credit expansion, and a reduction in savings. In turn, the reduction of productive investment into the economy has led to slowing output. As the economy slowed and wages fell, it forced the consumer to take on more leverage, which also decreased savings. As a result of the increased leverage, it diverted more of their income into servicing the debt.
Therefore, since interest rates, wages, inflation, and monetary velocity are a function of organic economic growth, debt increases correspond to the 40-year decline in prosperity. (Economic composite comprises of wages, inflation, and interest rates.)