After eleven years of nearly uninterrupted advancement, the record-long, QE-spawned bull market is on life support, facing the effects of pandemic lockdown and a massively leveraged global financial system. The sheer scale of the equities super-rally (larger than the dotcom and housing bubbles combined) is dwarfed by the magnitude of the monetary policy experimentation that was its foundation (Figure 1).
Figure 1: S&P 500 and Fed Balance Sheet, January 1995–April 2020
Rather than spurring real economic gains, the main outcome of the Federal Reserve’s unorthodox Quantitative Easing (QE) program has been to support, and further extend, the bloated and fragile debt grid, and generate exuberance in interest rate–sensitive risk assets like the stock market and real estate, fueling the largest wealth gap since the 1920s. It does this by suppressing the price of risk. Artificially low interest rates encourage unproductive debt accumulation and maintenance, and funnel money out of safe assets (through induced zero or negative yields) and into higher-risk assets with present value income streams that look a lot rosier in a depressed cost of capital environment. Known as the portfolio rebalancing channel of QE, this phenomenon drives asset value distension, malinvestment, and excessive risk taking.
Not surprisingly, the extra easy money regime of the last twelve years has lured worldwide debt to a historic high of 322 percent of GDP, 40 percentage points higher than in 2007 according to the IIF April 2020 Global Debt Monitor. “The size, speed, and breadth of the latest debt wave should concern us all,” said World Bank Group president David Mappass. Never have we seen this scale, involving both public and private debt and most of the world, warns the World Bank in Global Waves of Debt. Meanwhile, despite tepid real GDP growth and stagnant corporate profits, the S&P 500 climbed 360 percent between February 2009 and February 2020, powered by record-high debt-financed share buybacks.
However, central bank yield repression can generate debt-propelled asset exuberance only as long as there is capacity for more debt. The central bank’s bubble rebloat campaign will face new stumbling blocks this round as it confronts an overextended private sector. Furthermore, the counterweights to economic growth (partially QE grown) may finally be too large for the stock market to overlook.
Stumbling Blocks to Bubble Rebloat
Private Sector Debt Is Maxed Out
The US traded the dotcom bubble for a housing bubble and substituted the housing bubble with a share buyback Super Bubble. Each bubble required the private sector to load up on debt. US household debt had grown to 100 percent of GDP when the 2008 bubble burst, and, before this year's first-quarter (Q1) contraction, US household debt is still 76 percent of GDP (Figure 2). In the midst of the 2001 recession, Paul Krugman urged “To fight this, the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of PIMCO put it, Alan Greenspan needs to create a housing bubble to replace the NASDAQ bubble.”
Following Krugman’s kick-the-can-down-the-road recommendation, to help inflate the housing bubble replacement, the debt hot potato was passed to businesses. Nonfinancial corporate debt grew nearly 70 percent over the last decade and total nonfinancial business debt stands at 84 percent of US GDP (before the contraction), a record high (Figure 2). Both the International Monetary Fund (IMF) and Bureau of Industry and Security (BIS) estimate that about half of US corporate debt is now speculative grade (Figure 3). Also precedent-setting is the percentage of corporate debt with near-junk status; for the first time, BBB-rated debt represents the largest portion of investment grade debt.
Figure 2: US Debt Bubble, 1950–2019
Figure 3: Debt Rating Distributions in the US, GB, and EU, 2000–2017
Contributing to the quality deterioration, a sizeable portion of the $4 trillion in new corporate debt amassed over the last decade was used for financial risk taking, to fund shareholder payouts in the form of share buybacks and dividends. The S&P 500 spent more than $5.4 trillion on stock buybacks between 2009 and 2019, 50 percent more than all three QE programs combined (Figure 4). S&P 500 dividends also broke records, totaling another $3.4 trillion over the same period (Figure 5). “Payouts—dividends and share buybacks—at US large firms have grown to record high levels in recent quarters,” and are “often funded by debt,” warned the IMF in its October 2019 Global Corporate Stability Report. This is “in contrast with subdued capital expenditures,” the report continues. Citing a 2018 Yardini study, journalist Larry Light cautions, “More than half [56 percent] of all stock buybacks are now financed by debt.”
Figure 4: S&P 500 Stock Buybacks, 1999–2019
Figure 5: S&P 500 Dividends, 1999–Q1 2020
Share Buyback Helium Is Running Low
QE-abetted buybacks helped mask the weakness in GDP growth, corporate profits, consumer spending, capital expenditures, and productivity. But record-high debt levels, pandemic pressure on earnings, and escalating antibuyback sentiment may prevent their swift return. A two-decade study in the Financial Analysts Journal covering forty-three nations concluded that buybacks are a major bull market catalyst, more important than economic growth. The report finds that “net buybacks explain 80 percent of the dispersion in stock market returns since 1997.” In fact, corporations have represented the major source of demand for equities since the Great Recession. John Authers reports:
For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.
Similarly, in a February 2019 New York Times article “This Stock Market Rally Has Everything But Investors,” Matt Phillips writes, “The surge in buybacks reflects a fundamental shift in how the market is operating, cementing the position of corporations as the single largest source of demand for American stocks” (Figure 6).
Figure 6: Cumulative Net Purchases of US Corporate Equities, 2009–2019
In addition to the price inflation effects of colossal corporate demand, share buybacks are a powerful bull market propellant, because they reduce the denominator in the earnings per share (EPS) calculation, thereby boosting EPS numbers and concealing limp real income growth. Although overall corporate profits have been stagnant since 2012 (Figure 7), growing only 1.6 percent (with pretax profits actually declining 4.1 percent), S&P 500 earnings per share grew 68 percent during the same 2012–19 period.
Figure 7: Corporate Profits Pre- and Post-Tax, 1980–2019
However, sentiment in Washington is viciously turning against buybacks, with some politicians calling them a form of share price and management compensation manipulation. Securities and Exchange Commission (SEC) commissioner Robert Jackson in a June 2018 speech commented on the disturbing results of an SEC study covering 385 buybacks over fifteen months:
In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement….So, right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.
Senators Schumer and Sanders are agitating for limitations on buybacks. Senator Rubio wants to change the preferential tax treatment of buybacks. Senator Tammy Baldwin wants to ban them altogether. Former Treasury secretary Larry Summers has spoken out against them, and COVID bailout covenants include explicit restrictions on future buybacks.
Aiding the hostility are three decades of stagnant wages for middle- and low-income Americans as the costs of housing, tuition, childcare, and healthcare have swelled. Lance Roberts reveals, “Since 2007, the ONLY group that has seen an increase in net worth is the top 10 percent of the population, which is also the group that owns 84 percent of the stock market.” The Wall Street Journal explains that
the median net worth in the middle 20 percent of income rose 4 percent in inflation-adjusted terms to $81,900 between 1989 and 2016….For households in the top 20 percent, median net worth more than doubled to $811,860. And for the top 1 percent, the increase was 178 percent to $11,206,000.
The scale of the wealth gap has helped propel the Political Stress Index to its highest level since the Civil War (Figure 8). Although corporate demand for shares has been a decisive contributor to the last two stock market bubbles, the accelerating populist resentment, high levels of speculative debt, and earnings hardships ahead will reduce its presence this cycle, withdrawing a critical component of bull market jet fuel.
Figure 8: The Political Stress & Well-Being Indices, 1780–2000
With households and businesses bursting with debt, the Fed can’t rely on suppressed rates to induce extra debt-fueled consumption, unproductive private investment, or share buybacks. There isn't enough debt capacity left in the private sector to drive the inflation of the next bubble (Figure 2). “The only major debt category left that is big enough to play a role in the economy is government debt,” writes economist Klajdi Bregu in “The Fed is Running Out of Bubbles to Create.”
The Fed Is Monetizing New Heights of Government Debt
“At this rate the Fed will own two-thirds of the treasury market in a year,” cautions Jim Bianco in “The Fed’s Cure Risks Being Worse Than the Disease”—but that won’t reflate the stock market. In Japan, government debt expansion for stock market kindling was unsuccessful. The Nikkei has never regained its 1989 high even though Japan’s government debt has ballooned from 64 percent to 237 percent of GDP (the highest in the world) over the last three decades. The Bank of Japan (BOJ) now owns 50 percent of Japan’s bond market (Figure 9).
Figure 9: Nikkei vs. Japanese General Government Debt, 1950–2019
Even with seven years of QE that included direct stock market purchases—granting the BOJ the dubious honor of also being the largest owner of Japanese stocks—the Nikkei stubbornly remained 40 percent below its 1989 high at the end of last year. The intervention swelled the BOJ balance sheet by nearly 300 percent between 2012 and 2019; it is now the size of the entire Japanese economy (Figure 10).
Figure 10: Nikkei vs. Bank of Japan Balance Sheet, 1950–2019
Ronald Reagan said that “the nine most terrifying words in the English language are: I’m from the government, and I’m here to help.” The government can issue debt to hand out money, but they can't force people to spend it in ways that help the economy. And the impulse to defer spending, reduce debt, and save money is acute in high-uncertainty, high-pain environments like the current one. Personal consumption expenditures as a percentage of GDP were already flat during the last decade (after having climbed for thirty years) as consumers began to delever to still-high current levels (Figure 11). Temporary government handouts to dampen the effects of the lockdown economy aren’t likely to reverse this trend.
Figure 11: Personal Consumption Expenditures as Percentage of GDP, 1959–2019
And despite significant increases in business debt, fixed private investment as a share of the money supply (printed for its very encouragement) remains at 2009 crisis lows. This is also reflected in capital expenditures as a percentage of GDP, which never recovered their pre–Great Recession or long-run levels (Figures 12 and 13).
Figure 12: Fixed Private Investment as a Share of M2, 1981–2019
Figure 13: Total Capital Expenditures as a Percentage of GDP, All Sectors, 1947–2019
Lobbing the Debt Timebomb at the Government Has Steep Costs
High government debt kneecaps economic growth. Not only are government-debt-for-handouts schemes ineffective at hotwiring sustainable growth, but it turns out that elevated public debt cannibalizes GDP growth. A 2010 study by Reinhart and Rogoff found that when government debt exceeds 90 percent of GDP, “growth rates are roughly cut in half.” But a World Bank investigation found the destructive debt threshold to be lower: every percentage point of public debt greater than 77 percent of GDP costs 0.0174 percentage points in real growth. The US crossed the 77 percent precipice in 2009, and average annual real GDP growth since then has been nearly 45 percent lower than in the previous sixty years, a period that encompassed eleven recessions (Figure 14). In trading terminology, we would consider this a poor upside-downside capture ratio. By trying to limit the economy’s downside volatility, the Fed has constrained the upside, and, as 2020 will show, the policy has made the downside far worse.
Figure 14: Real GDP Growth vs. Government Debt, Q1 1948–Q1 2020
Japan traversed the fateful 77 percent Rubicon in the early 1990s. In the decades since, real GDP growth has averaged about 80 percent lower. “Japan’s ‘lost decade’ eventually extended to almost three decades of sub-par growth,” writes Dr. Mihai Macovei in Stimulus Brings Stagnation (Figure 15).
Figure 15: Japanese Annual GDP Growth vs. Government Debt, 1970–2018
US government debt (excluding unfunded social security and Medicare liabilities) is now approaching 130 percent of GDP, exceeding the record of 118 percent set during World War II. This astronomical debt load will not only weigh on economic growth but also on share buybacks, which can cheerlead stock market performance only as long as they can be funded (with earnings and/or debt). But as already stagnant corporate earnings are anchored by a debt-dragging economy, the most important demand source for stocks this century will remain in hibernation.
The Fed Is Breeding Zombies
A debt-promoting easy monetary policy adds another burden on economic growth and productivity: zombie proliferation. A 2018 study in the BIS Quarterly Review by Banerjee and Hofmann found that “lower nominal interest rates predict an increase in the zombie share [older public companies with earnings too low to meet interest payments].” These “living dead” firms that should pursue restructuring or bankruptcy are instead kept alive by discounted interest rates and evergreen lending. As with government spending, zombie firms crowd out productive investment and employment. Using a narrower definition of zombie that additionally factors in low expectations for future profitability, Banerjee and Hofmann determine that “a one percentage point increase in the narrow zombie share in a sector lowers the capital expenditure of non-zombie firms by around one percentage point.”
Prior to the COVID crash, an estimated 16 percent of US public companies were zombies. That number will grow as the Fed nationalizes large expanses of corporate debt markets and government policies prop up marginal firms and add restrictions (e.g., government ownership, workforce freezes, and payout controls) that will make them even less competitive going forward (Figure 16). Average US productivity over the last decade has already been 58 percent lower than the previous six decades; at the end of 2019, it had fallen to a Japan-like low of just 1.2 percent.
Figure 16: Share of “Zombie Firms,” Euro Area (EA), GB, and US, 2000–2017
A portentous example of the path to zombiehood and the incentive perversion generated by government subsidies and ownership is offered by the railroads in the late nineteenth century. Government aid for the Union Pacific (UP) and Central Pacific (CP) railroads encouraged track-laying speed over railroad efficiency. Grant payments were higher for construction on hilly or mountainous terrain. “This incentive for speed resulted in winding, inefficient routes built with inferior materials, ultimately culminating in a federal price tag of 44,000,000 acres and $61,000,000 (astronomical sums in the 1860s–70s). Despite all of this federal assistance, shortly after the golden spike was driven on May 10, 1869 at Promontory Summit, Utah, the UP and CP were nearly bankrupt and required further assistance to stay afloat….they ultimately went bankrupt in 1893,” explains Dane Stuhlsatz.
Tenured insolvent businesses sustained by repressed rates and government underwriting have been blamed as one of the causes of Japan’s economic stagnation and lost decades. An estimated “two-thirds of the nation’s companies don’t make enough profit to pay taxes,” contributing to the downward spiral in productivity and GDP growth. Japan’s GDP per hour worked has nosedived nearly 70 percent, from an average 4.2 percent pre–bubble bursting, to just 1.4 percent since 1991 (Figure 17).
Figure 17: Japan Productivity Growth, 1971–2018
An accelerating zombie share will constrain US productivity growth when it is needed most. Sleepwalker firms underperform in the broader market, and as they propagate like a virus through US companies, they will add another ball and chain to a stock market already suffering from demand destruction
The Last Stand: The World's Biggest Debtor Tries to Guarantee Everyone Else’s Debt
The Fed has relied on the temporary camouflage provided by manipulated risk asset exuberance and related wealth effects (benefiting a high income–earning minority) to cover up the economy’s post-QE failure to thrive. Now, with more than a decade of ultralow rates, the entire world is stuffed with debt and the leverage encouragement portion of the QE formula is facing its limits.
The program’s last stand is to double down, hoping that artificial demand from QE infinity will keep rates low enough to limit private sector delevering and brace the stock market while the debt timebomb is passed to the government and the world’s biggest debtor tries to prop up everyone else’s debt. However, high government debt, bankrolled with QE Monopoly money, won’t save the stock market Super Bubble. It will only deepen the economic stagnation and perpetuate the negative feedback loop that requires ever more intervention, debt, and printing to monetize it.
Even the Fed acknowledges the “apparent ineffectiveness of credit easing (CE) [a.k.a. QE] on aggregate output and employment” in “Evaluating Unconventional Monetary Policies—Why Aren't They More Effective?,” by Yi Wen.
Rather than more socialization of the economy, we need a return to free markets: a shift away from centrally planned rate suppression that blows up financial bubbles; an embargo on bailouts that propagate moral hazard and prevent the productive redeployment of labor and resources; a contraction in government spending to reduce crowding out of valuable private sector employment and investment; and a rejection of distortive intervention in the debt markets. Although these changes would initially be painful, they would lead to regeneration and a true boom. The current path is toward a slow stagnation death as the central bank eats the economy.
The Nikkei rose 360 percent between 1982–1989 and then fell 73 percent over twenty-three years. Even with the BOJ buying 5 percent of the Japanese stock market, the Nikkei is at the same level it was in 1996, 40 percent below its peak, illustrating QE’s diminishing “returns.” The US has a 2019 bubble to rival Japan’s 1989 bubble, and it’s following the same Monopoly money prescription to try to save it but expecting a different outcome. The Fed is setting the economy and the stock market up for a lost “decade.”
Today is already the tomorrow which the bad economist yesterday urged us to ignore. (Henry Hazlitt)