June 16, 2020
If this post comes off a little short on detail, that’s because it only highlights an idea, it doesn’t come close to doing justice to the topic. The issue at hand is that cash flow matters, to individuals, to companies, to governments . . . and there isn’t enough of it.
The accumulation of debt can serve two purposes. One is the formation of capital for large projects such as building a highway or hospital, perhaps a factory or a ship. These assets will then be paid for over time with excess cash flow from the operation of the assets, or in the case of government, the collection of taxes.
The second purpose is to cover the payments for things that have already been purchased. This is the realm of payday lending, reverse mortgages and ever more corporation and sovereign government.
All of this is brought on by the bankruptcy of another company, a former ‘Unicorn’ company, Proteus Digital Health, which fell into bankruptcy overnight. Once valued at $1.5 billion, it can’t pay it’s bills. They have raised over $500 million dollars, and it is clearly all gone.
My ‘bankruptcy watch’ page lists many companies who have been sunk by their debt, and while some will continue operating once the dust settles, the equity holders will be wiped out. If you aren’t familiar with what that means, it means that equity holders typically get nothing, debt holders typically get 30-70 cents on the dollar if the assets can be liquidated or continue to operate and in that case, the debt holders will be the new owners of the business. Management is usually removed as well.
Chesapeake Energy is probably next, but the market has been saying that for well over a year. Either way, Chesapeake will certainly need to restructure.
The market is rife with these stories. The failure of WeWork to raise funds in a bid to go public is another example when a valuation gets reworked down from the ‘perceived value’ to the actual value. In their case, the company told the market (in the world of private equity, where we make up numbers to suit our needs) that they were worth $47 billion. After WeWork completed their filings for their failed IPO, it was clear that the numbers didn’t add up, and now the company is valuing itself at $2.9 billion. That’s down about 90% for those that need help with the math. The culprit? Their income can’t support their debt.
While stock markets continue to avoid the same ‘re-valuation’, the issues are strikingly similar, even if the result would be less severe. The real danger now is that governments around the world have taken on all of that valuation risk and economic collapse is a significant risk (think Greece or South Africa). That ignores the political risks (think Venezuela, Turkey or Egypt), but the risks are rising everywhere and when the props fall, the downside is swift and unforgiving.
There are a few proxies that highlight the problem, and are worth watching. They include interest payments for the US debt which you can find here. Currently the zero interest rate policy of the Federal Reserve is the only thing keeping debt from overwhelming America (and by association, Canada and Mexico).
The second is foreign holders of US debt. The only way that debt load can be sustained is if there are enough buyers for that massive amount of debt, and international buyers are key to making that happen. The most up to date data can be found here. A good visualization for the current status can be found on HowMuch.net. And a further visualization of the changes over time (in this case only to 2014!) can be found on Wikipedia.
What is scary is that much of this investment is made in the US because of the stability of the country and its currency. There is an effort underway to reduce the importance of the US dollar as a reserve currency, and this will reduce the need to hold US treasuries for trade purposes (think China, Japan and the EU). The Bureau of Economic Analysis publishes a lot of data to examine investment into and out of the US. The latest data for the US International investment position shows that US residents owe the rest of the world about $11 trillion.
The final metric is the US dollar. This blog reviewed the importance of the reserve currency and the dollar a few weeks ago, and now the really smart guys are starting to talk about it in public as well. Stephen Roach discuses it here.
The dollar continues to look weak, but not terrible because there is so much fear elsewhere, but excessive debt and autocratic leanings of Trump are challenging the notion that the US is a safe harbor. That combined with the efforts by China, Russia and even the IMF to offer options to the US dollar as the reserve currency of the world mean that the US dollar has perhaps peaked in importance.
Below is a long term graph of the US dollar. Note that the dollar has generally risen with the last two democratic presidents.
One aspect of this is that a weaker dollar makes exports cheaper. Another theme here has been that the world economy is slowing (long before COVID-19, as can be seen below), and since first world economies don’t need to buy as much stuff, the answer is to export. A lower dollar helps with that. Here is what exports have done over the past 30 years using the same time scale as the dollar chart above. Note that a weaker dollar generally results in a rise in exports. (But the effect is getting weaker!).
So when does it all pop? TINA (there is no alternative) is driving market performance and central bank support for assets is providing a sense of calm, but it isn’t based on value. Predicting these events is difficult, even in a perfect world, but standing aside with enough cash to withstand major market turmoil is a good choice unless you are very young with a good income, or very wealthy and don’t need to worry about money.
Be cautious, stay safe.
A brief look at the list of countries by their government budget for the 2017 budget year shows that the major economies showing a surplus are Germany, S. Korea, Netherlands, Sweden, Switzerland, Norway, Taiwan, New Zealand and Hong Kong. That’s it in the top 50 largest economies, nine countries. Of all 228 countries only about 40 ran a surplus in 2017, and most of those are small island nations with GDP of less than 200 billion.