Friday, October 2, 2015

The Third Wave: Debt-deflation spiral reaches the corporate sector

Already two years ago I warned about the bursting of the Emerging Markets bubble (see for example Developed markets growth improvementvs. busting EM bubble dated August 23 2013). While in the meantime growth in the Eurozone has improved, the situation has indeed worsened across a large number of emerging markets and commodity producing economies. In fact I now think that important parts of the EM and commodity producing corporates face a new debt-deflation spiral which slows down world trade and has already started to negatively impact the US economy.

From 2007 onwards, the unwinding of real estate bubbles forced the overleveraged banking system into deleveraging mode. The resulting adverse and self-reinforcing feedback loop (lower asset prices - weaker banking sector balance sheets - more restrictive credit environment & selling of assets - weaker economy & lower asset prices) threatened the global financial system. This systemic crisis could only be overcome with the help of central banks providing an unprecedented amount of liquidity support and massive fiscal easing programmes. In addition, important financial institutions had to be bailed-out and bad assets were transferred onto the sovereign balance sheet. In order to render the banking system less vulnerable, Over the past years, banks had to secure additional capital and reduce the size of their balance-sheets, thereby lowering their leverage ratios. Due to the massive support programmes the fiscal positions of a large number of developed market sovereigns deteriorated markedly as debt-GDP ratios and budget deficits soared. In turn, debt-dynamics worsened materially and from 2011 onwards, the Eurozone peripheral countries suffered a sovereign debt crisis. 
During this second wave of the global debt-deflation spiral, yields on peripheral debt skyrocketed and the peripheral sovereigns lost market access. Sovereigns were forced to implement drastic fiscal tightening measures which, however, forced their economies into recessions, thereby aggravating the debt crisis. Only with the help of the Eurozone core sovereigns fiscal capacity (via the EFSM/ESM) and the ECB (initially via the SMP and then more importantly the OMT and lately QE) this negative feedback loop could be broken. While debt-GDP ratios remain at very high levels, deficits have been reduced materially in the meantime and with the help of record low yields projected debt dynamics have been improving materially. 
The banking sectors in the US and Europe have been gradually emerging from the financial crisis and leverage ratios have been reduced significantly. Lately also the peripheral Eurozone countries have seen growth rising back into positive territory while the fiscal positions have improved. Now, however, a new third wave of the global debt-deflation spiral is gathering strength , this time in the corporate sector – mainly but not exclusively in the commodities and emerging markets (EM) space. During the past decade, EMs have grown strongly and as these economies exhibit a high commodity intensity of growth, the demand for commodities increased markedly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. Moreover, just as the global economy emerged from the financial crisis from 2009 onwards, capital flows into EMs and commodity producing economies skyrocketed. On the one side, these countries had healthy fundamentals and a favourable structural growth story. On the other side, investors in Europe and the US wanted to leave their home countries amid the dire state of their economies while the ever increasing supply of central bank money via liquidity provisions and QE put downward pressure on the currencies. In turn, the annual capital inflow into emerging market economies increased from USD 500bn per year in the 2000-2007 period to USD1.100bn in the 2010-2013 period according to the World Bank. Furthermore, the cumulative issuance of external bonds increased from USD 520bn in the eight years up to the financial crisis to USD 1490bn in 2010-2013. Finally, most of the growth in external issuance occurred not from the sovereign sector but from the EM corporate sector. Asia – in particular China - and Latin America were at the forefront of this process as the chart below shows. In addition, the commodity and construction sectors were responsible for the bulk of increased issuance activity. 
As a result, corporate debt relative to GDP increased to approx. 75% across the EM world by 2014 according to the IMF. However, at the same time the growth backdrop has deteriorated markedly starting around 2013 given the build up in (private sector) indebtedness, a loss of competitiveness, rising current account deficits/falling surpluses and growing political risks in a number of countries. Furthermore, the Chinese economic growth is trending lower on a structural basis amid lower productivity growth, worsening demographics and as the economy shifts from manufacturing to services. As a result, the supply-demand balance for most commodities has shifted fundamentally as past investments lead to increasing supply while the muted economic dynamic dampens demand growth. On the other side, systemic risks in the Eurozone have receded while real growth in Europe and the US has been slowly rising. Moreover, as QE in the US has ended and with the Fed moving closer to rate hikes, the US-Dollar has started to appreciate considerably. In turn, capital has been flowing back into the US and Europe and out of EMs and commodity producing economies, putting downward prices on their exchange rates and asset markets. This, however, results in another increase in corporate sector balance sheet leverage as shown by the left-hand chart below. Moreover, as foreign currency debts – largely in USD – have become more popular, the rising USD increases the value of debt while revenues are under pressure given low commodity prices and weaker growth. Hence, there is a new negative feedback loop in progress as a drop in revenues/profitability coupled with high leverage ratios will see an ever increasing share of revenues being devoted to debt service. Pressure mounts to cut costs or dispose of assets which, however, weighs further on economic growth and asset prices. Rising corporate bond yields are only aggravating this process and an increasing number of corporates risks losing bond markets access if this debt-deflation spiral worsens. 

Corporate leverage and debt ratios have been rising markedly
 Source: IMF

This is a corporate sector crises in a growing number of countries and also increasingly affects some corporate sectors in Europe and the US (for example basic resources & materials, machinery & equipment etc.). Given that in comparison to the banking sector corporates exhibit lower leverage ratios and usually have longer maturity bonds outstanding rather than vast amounts of very short term paper, this debt-deflation process should be of a slower nature than the first two waves. In addition, the sovereigns of most affected economies are not overly indebted and several have significant fx reserves which they can use to support the domestic currency or to bail-out parts of the corporate sector. Nonetheless, growth across EMs and commodity producing countries promises to slow down even further/remain at low levels for some time. This should weigh on global growth as well as trade flows and keep disinflationary pressures alive. 
As time progresses, the damage to the European and US economies should become more noticeable. US growth will likely moderate somewhat to around 2%. While the & gas sector is suffering from the collapse in energy prices and the internationally focused large corporates remain burdened by the strong USD, the more domestically oriented smaller corporates as well as the services sectors are doing ok. This is also being mirrored by the discrepancy between the ISM manufacturing and the non-manufacturing indices (see left-hand chart below). Industrial production growth has already slowed down markedly to only 0.9% yoy in august. However, growth in real personal consumption expenditures (which account for roughly 70% of GDP) remains above 3% yoy and is supported by the combination of a robust housing market, ongoing albeit weakening employment gains as well as the collapse in energy prices which restores households’ purchasing power. 

US (left) and Eurozone (right) service vs. manufacturing PMIs
 Source: Bloomberg
For Europe, the export environment will likely deteriorate as well over the quarters ahead. However, export shares of Eurozone countries going to the US and the rest of other Western Europe (ex. Norway) are about 2.5times as high as the export shares going to all emerging markets. Hence, the European economies depend mostly on each other and the US. As these countries remain in moderate growth mode, the export slowdown should not be dramatic. More importantly, the combination of easing negative growth effects of fiscal tightening efforts, record low interest rates – with finally also an accommodative monetary policy environment in the peripheral countries – the collapse in energy prices and the restoration of internal competitiveness in parts of the periphery should continue to support the economy. Similar to the US, though, the gap between services and manufacturing PMIs promises to become even more pronounced. Hence, while global growth is subdued and likely to moderate further, the domestic oriented parts of the European and US economies US should do ok, thereby preventing a sharper slowdown. Inflation, though, promises to be very low for longer with inflation expectations likely to drop further as upward pressure on currencies and downward pressure on commodities persist. 
The US Fed remains focused on starting a very gradual rate hiking process as the domestic economy remains in growth mode while they regard current low inflation rates as transitory. For the corporate debt-deflation spiral, however, such higher US policy rates are part of the problem as they threaten to propel the USD and corporate bond yields to even higher levels. The ECB on its part will likely adjust its QE programme amid very low inflation expectations via extending the minimum buying period beyond September 2016. 

 Credit risk is being repriced into corporates just as sovereigns have regained the safe-haven status
 Source: Bloomberg
A renewed fundamental shift in the supply-demand balance for commodities, a large dose of fiscal easing in China or a new round of US Dollar liquidity creation (aka QE4) would likely be able to break or at least significantly ease this debt-deflation spiral. For the time being, though, the situation for those corporates located in or being strongly dependent on emerging markets or commodity producing countries will probably become even more challenging. As a result, a cautious stance towards global corporate risk remains warranted. Sovereign debt should still be favoured over corporate debt and the sovereign bond outperformance has likely not yet ended. Within developed markets, domestic, services and household goods oriented as well as smaller corporates should be favoured over export dependent and manufacturing oriented as well as larger and highly indebted corporates. In general, it seems too early to move back into emerging markets and into commodities with the notable exception of precious metals where strategic longs can slowly be opened.