Bank of America: “Corporate Balance Sheets Are The Most Unhealthy They Have Ever Been”

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BofA’s HY credit strategist Michael Contopoulos, whose work we have recently presented on several occasions, has been rather dour over the past year on the future of HY debt, as the junk bond market first descended into purgatory, and then right into the 9th circle of hell, courtesy of a collapse in the energy sector unlike anything seen in history…

… a collapse which virtually everyone admits will spread into all other sectors and products: it’s just a matter of time.

However, rarely if ever have we heard Contopoulos as downright apocalyptic as he is in his latest note, “A Minsky Moment”, which has to be read to be believed, if only for the selected excerpts below:

With a view that the market will eventually price in a much worse default environment than it is currently, we are left trying to determine when peak spreads will occur and for how long they will last. Unfortunately, when peak spreads are reached is not consistent across time periods, making it difficult to time the optimal entry. For example, in 1989 spreads peaked 178 days before the default rate peaked, in 2002 it was 165 days after, and in 2008 it was 290 days before (Chart 2). Convoluting the picture today is that the Energy default rate has the potential to skew that of the overall market. For example, if high yield E&P companies realize a 50% default rate this year and the rest of Energy experiences a 25% default rate, the Energy component of the market default rate could be nearly 6ppt. If the rest of the market experiences just a 4ppt rate, the market could realize double digit default rates in 2016, despite a relatively benign  non-commodity contribution.

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In our opinion, however, we think the biggest issue in the market is the buildup of corporate leverage without a place for it to go. And what will likely cause peak spreads is not an increase in defaults, but a capitulation moment that creates a rush for the exits. In this way, we think the 1989 and 2008 cycles are more representative of what we could see this go around, as max spreads occur before the highest defaults – whether that is in 2016 or 2017 will depend on the timing of the catalyst.

* * *

Although we have argued for some time that what matters to market performance is underlying fundamental growth, we have further argued that should high yield be the canary in the coal mine for earnings and the macro economy, the ensuing crisis is likely to be one defined by the excessive credit creation in the corporate market. Should a market meltdown be accompanied with a lack of inflationary pressure, the credit creation of the last 5 years will likely be met with a period of significant credit destruction.

And in a world where corporate balance sheets are arguably the most unhealthy they have ever been (all-time high leverage in HG and HY) where companies have relied on cheap debt to fund a growth through acquisition strategy, what happens if funding is either unavailable or too expensive to make a growth through acquisition strategy make sense? Same goes for buybacks and special dividends? Then one would have to cut capex. But with little capex to cut, personnel could be cut next (particularly if those people are beginning to cost more). And when coupled with a consumer that is already saving 5.5% of disposable income, should we see layoffs amidst an already low GDP, poor CEO confidence, and banks that are risk averse and perhaps hurting with commodity exposure, things could potentially get messy in such a scenario.

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… perhaps the biggest innovation of the post-GFC years, and potentially the most detrimental and levering, was the massive increase in the Fed’s balance sheet on the back of quantitative easing. As the Fed’s financial engineering created a lack of yield globally, opportunities to invest in corporate debt abounded both within the US and globally. Although consumer and bank balance sheets have been repaired, the post-GFC easy monetary world created an unsustainable thirst for corporate debt that earnings growth never supported (Chart 9 and Chart 10).

Herein lies our concern for markets and where the fear of a Fisherian debt deflation spiral can become worrisome. Although it is unlikely that the corporate market is enough to cause outright deflation, certainly a corporate credit bust can create disinflation or enhance deflation if it already exists. As liquidation leads to falling prices, dollar strength causes the very debt that needs to be paid down all the larger. Liquidation leads to defaults and layoffs, which, in a post-Volcker world, would likely cause banks to pull back on lending even further. The lack of lending coupled with job losses could create a weak consumer, which would further propagate a negative feedback loop to corporate earnings and further liquidation. Although we stress that this is not the scenario our economists envision for the US economy, we think attention needs to be paid to the potential impact credit markets can have on the macro economy, should the debt deflation cycle kick off.

And in a subsequent post we will lay out the three potential catalysts to the capitulations that BofA believes could unleash the endgame of this particular cycle of central planning. 

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