If you are wondering what the biggest threat to the U.S. equity markets is then look no further because the votes are in. No, it is not earnings (not directly anyways), not energy prices or the Euro, and not even the continued uncertainty being generated from the U.S. election – it is corporate bonds. As the new paradigm attempts to piece together part of its broken frame (tech stock prices) a funny thing is beginning to happen – the corporate bond market is drying up. This is interesting because a prolonged drought in corporate bonds could have a direct impact on productivity gains, gains which Wall Street habitually makes reference to, but more on this topic later. Suffice it to say, investors who previously had a seemingly insatiable thirst for corporate debt are stepping away from the table - partly because of the slump in stock prices, but mainly because of the toxic byproducts produced from higher interest rates and a slowing economy: that being credit quality. The quality of outstanding debt in corporate America is deteriorating, has been for over 10 months, and with interest rates high and fears over quality mounting, bringing new debt to the markets has become more expensive. The key here is 'more expensive' – the assumption being that debt makes it to the market at all. For those unacquainted with recent trends in the junk (high yield) market, one of the more shocking developments occurred when Levi Strauss shelved a $350 million offering on October 24. The popular name 'Levi's' has not been back to the market yet… Just days before Levi Strauss pulled its offering, yields on junk reached nearly 14%, more than 8 percentage points above that of U.S. Treasurys – or a higher mark than was present during all of the Russian crisis of 1998. This occurrence immediately set the Wall Street sales machine in motion: "You have to be a little more selective than to simply say you don't like the corporate bond market, You cannot taint the entire market with a negative brush because of blowups." Eli Lapp, senior vice president and corporate bond strategist at HSBC Securities Inc. in New York. "I think the market is overestimating the risk," Scott Grannis, who helps manage $70 billion of fixed-income assets at Western Asset Management Co. in Pasadena, Calif As Mr. Lapp suggests, you can not taint the entire corporate bond market or he would not have a job, and as Mr. Grannis points out the market may be overestimating risk – a polite way of saying the outlook is grim, but perhaps not that grim. As if the word 'grim' means much to those holding on to corporates while the economy wheels lower and risk builds… Rather than be selective or think that the markets are overestimating risk, it should be said that the blow-ups at the junk level may be highlighting disaster ahead. The high-yield market is significantly larger than it was 10 years ago (it has more than doubled to $680 billion), and the last time junk swayed as far as they are today from investment grade bonds was back in 1990 - in that case a recession soon followed. Are stock prices ready for a recession? Do banks have enough loss reserves in the vault for a recession? The questions which can be extrapolated with the mere mention of the word 'recession' are endless, but there remains no question to the fact that junk bonds are taking a beating, and have been for some time: Moody's estimates that investors throwing $10,000 into an average junk fund three years ago would have $7,500 today (less dividends). Additionally, the junk market has increasingly become the choice (or only alternative) for many telecommunications and related 'new economy' stocks. As an example, Amazon.com would probably already be bankrupt if it were not for junk, and much of the new telecommunications infrastructure would be non-existent as no-name wonders would have been unable to secure funding. So, when companies like GST Telecommunications or ICG Communications go bankrupt and many others are lined up at deaths door, it is hysterical to think that equity investors do not believe this impacts the 'new economy' model. Remember, in the grandiose scheme of things the backbone of the new economy is not Cisco or any other top company, it is the ability of companies with horrifying balance sheets to get money (from any means possible) and bring new productivity enhancing technologies to the table. Ahh, productivity gains: that master of inflationary pressures and statistical captivator of investor's hearts. Now for the bad news, not only has weakness in corporate bonds played a major role in limiting capital spending now and in the future, so too will fewer IPOs, less venture capital, fewer M&A's, lower stock prices, and falling corporate earnings. Why Wall Street is not terrified of these slowdowns, especially since they are culminating in sync with one another, has to do with the fact that everyone seems to be looking at the current numbers. What the current numbers suggest is that the economic landing will be soft and it is assumed by most that investment flows will pick up in the new year. This defensive posture can be a dangerous one if and when unforeseen circumstances develop. Again, the word 'default' must be looked at. Turning To The Banks In the second quarter of 2000 bad loans began showing up in the 'loss reserve' columns on banks' balance sheets, and this trend is anticipated to intensify leading into the fourth quarter reporting season. A recent development is a tiny (by most standards) $1.5 billion loan to Sunbeam in which three banks are feeling the sting. But this bad loan sting is not an isolated phenomenon. The usually safe minded Sun Trust reported in the third quarter that non-performing loans, or loans which companies have missed payments on, climbed higher by 60%, or to $381 million from $237 a year ago. This data implies that Sun Trust will have to raise charge-offs due to bad loans in the fourth quarter. As well, considering the company had bad loan reserves sitting at 1.48% of total loans in the third quarter of 1999 and in 2000 this number has slid to 1.21%, it is not that difficult to foresee possible profit strangulation – money must be shifted to raise the loss reserves. The question is, why is the usually safe minded Sun Trust keeping reserves so low? Does trying to match Wall Street's numbers have anything to do with it? Moreover, how poorly will bank earnings be if the economic slow down turns out to be more abrupt than most expect? When you add to this list of concerns that fact that defaults are expected to soar in the fourth quarter, there should be serious concern over how the Banks are going to cope. Moreover, concerns have intensified in recent days: Moody's now foresees an 8.4% default rate in September 2001, up from 5.3% last September. This grim forecast when combined with already tightening lending policies does not bode well for much of corporate America, particularly if the soft landing should waver off course. Consequently, knowing that defaults are expected to perk up for some time, this must make people wonder what the banks were doing in the first place… Greenspan's palpable adage that 'bad loans are made in good times' is worth remembering. But what specifically does a 'good times' policy do to make the 'bad times' bad? Perhaps the average investor today takes for granted that banks will always lend freely and openly? Perhaps the 85 rated defaults thus far this year are isolated events not having a systemic impact? Perhaps also we stand one major bombshell away from a credit crunch? Regardless of the alternating opinions, the fact remains that the economic slow down has both its pitfalls and possible rewards. As the smaller debt implosions are thought to be a long term threat to the 'new economy' this in turn must mean Mr. Greenspan is on the job: "To the extent that the Fed wants to make sure that there's indeed a soft landing and that the productivity-driven gains that we've had continue, there's clearly scope for bringing short-term rates down a little bit." Steven Wood, senior economist at Banc of America Securities in San Francisco. After this comment, one cannot be sure whether Mr. Wood is inebriated or simply blinded by the aura of Greenspan. The Fed is concerned with long-term sustainable growth, and has recognized, besides the dovish Fed McTeer who doesn't have a vote anyways, that productivity gains are miraculously high and will inevitably retreat in the future. To even suggest that Greenspan is now looking at productivity numbers and thinking of a rate cut does nothing more than soil all of our minds with savior wonderment. Greenspan, as per the FOMC minutes for October, realizes full well that the economy is slowing, and he must surely recognize that a continued slow down will lead us into a recession and crimp productivity advancements. Greenspan can not only be a bull market puppet, as some would have you believe. This is why deteriorating credit quality, and the future inflation gauge over at ECRI has him thinking, and what he may be thinking about is not what most want to hear (r-word). Considering that the U.S. economy is standing on shaky footing from a purely economic standpoint, what possible good would a rate cut do anyways? Stock prices would jolt higher, lending constrictions would begin to ease and indebted consumers would plaster even bigger smiles on their faces. Then what? Do earnings make the 'quality of debt' issue disappear, do productivity gains mastermind all inflation concerns? I'm sorry; the Fed is not ready to accept this type of voodoo monetary stance just yet. The Fed will only cut when some unknown pillar collapses or inflation is seen as being firmly under control. This much can be certified. The problem with the current economic slow down is that inflationary pressures have not followed suit. Credit market players may be attuned to speculating on short-term liquidity trends, but what they are not keenly aware of is exactly how many more defaults will arise if the economy does not fit into a picturesque slow down portrait. No one is all too sure about this. This means that any Tom, Dick or Abby offering a bullish scenario for corporates is judging the market on the 'buy the blood' adage. Buy the 'blood' rather than 'dips' because it is typically after a collapse, rumored or not, that fund managers reiterate their long-term bias. It is worth being careful when 'buying the blood', because Greenspan may not be able to bandage up long-term abrasions expected in corporates. All that can be agreed on is that everyone, Moodys, Standard & Poor's and most bond managers agree that defaults will intensify in the coming weeks and months. Therefore, since everyone is in agreement on the 'blood' aspect, corporate bonds must be observed as the biggest threat to the U.S. equity markets going forward. So, watch the defaults… Bank Loan Ratings By Issuer Name High Yield Issuer Rankings by Ranking Moody's Rating Actions |