Liscio Report - You're Gonna Need a Bigger Boat

August 04, 2015

Size matters. Just ask Roy Scheider. As incredulous as it may seem, I only recently sat myself down to watch that American scare-you-out-of-the-water staple Jaws for the first time. As a baby born in 1970, the movie at its debut in 1975 was hugely inappropriate for my always precocious, but nevertheless only five-year old self. And by the time this Texas girl and those Yankee cousins of mine were pondering breaking the movie rules during those long-ago summers in Madison, Connecticut, it was not Jaws but rather Brat Pack movies that tempted us. We started down our road of movie rebellion with St. Elmo's Fire, then caught up with a poor Molly Ringwald in Pretty in Pink and then really stretched our boundaries with Less than Zero - you get the picture.    

And so finally during this long, hot summer of 2015, a seemingly appropriate time with our country gripped from coast to coast with real-life shark hysteria, I watched Jaws for the first time and heard Roy Scheider as Chief Martin Brody utter those words, "You're gonna need a bigger boat."     

Prophetically, the reality might just be that the collective "we," and quite possibly sooner than we think, really will need a bigger boat. That is, as it pertains to the global debt markets, which have swollen past the $200 trillion mark this year rendering the great white featured in Jaws, which can be equated with past debt markets, as defenseless and small as a teensy, striped Nemo by comparison.

The question for the ages will be whether size really does matter when it comes to the debt markets. It's been more than three years since Bridgewater Associates' Ray Dalio excited the investing world with the notion that the levered excesses that culminated in the financial crisis could be unwound in a "beautiful" way. A finely balanced combination of austerity, debt restructuring and money printing could provide the pathway to a gentle outcome to an egregious era. In Mr. Dalio's words, "When done in the right mix, it isn't dramatic. It doesn't produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ration of debt-to-income go down. That's a beautiful deleveraging."

I'll give him the slow growth part. Since exiting recession in the summer of 2009, the economy has expanded at a 2.1-percent rate. I know beauty is in the eye of the beholder but the wimpiest expansion in 70 years is something only a mother could feign admiration for. That not-so-pretty baby still requires the wearing of deeply tinted rose-colored glasses to maintain the allusion.     

As for the money printing, $11 trillion worldwide and counting certainly checks off another of Dalio's boxes. But refer to said growth extracted and consider the price tag and one does begin to wonder. As for debt restructuring, it's questionable how much has been accomplished. There's no doubt that some creditors, somewhere on the planet, have been left holding the proverbial bag -- think Cypriot depositors and (yet-to-be-determined) Energy Future Holdings' creditors. Still, the Fed's extraordinary measures in the wake of Lehman's collapse largely stunted the culmination of what was to be the great default cycle. Had that cycle been allowed to proceed unhampered, there would be much less in the way of overcapacity across a wide swath of industries.    

Instead, as a recent McKinsey report pointed out, and to the astonishment of those lulled into falsely believing that deleveraging is in the background quietly working 24/7 to right debt's ship, re-leveraging has emerged as the defeatist word of the day. Apparently, the only way to supply the seemingly endless need for more noxious cargo to fill the world's rotting debt hulk is by astoundingly creating more toxic debt. Since 2007, global debt has risen by $57 trillion, pushing the global debt-to-GDP ratio to 286 percent from its starting point of 269 percent.    

Of course, the Fed is not alone in its very liberal inking and priming of the presses. Central banks across the globe have been engaged in an increasingly high stakes race to descend into what is fast becoming a bottomless abyss in the hopes of spurring the lending they pray will jump start their respective economies. Perhaps it's time to consider the possibility that low interest rates are not the solution.    

Debt is a fickle witch. When left to its own devices, which it has been for nearly seven years with interest rates at the zero bound, it tends to get into trouble. Unchecked credit initially seeps, and eventually finds itself fracked, into the dark, dank nooks and crannies of the fixed income markets whose infrastructures and borrowers are ill-suited to handle the capacity. Consider the two flashiest badges of wealth in America - cars and homes. These two big-line items sales' trends used to move in lockstep -- that is until the powers that be at the FOMC opted to leave interest rates too low for too long. In Part I, aka the housing bubble, home sales outpaced car sales as credit forced its way onto the household balance sheets of those who could no more afford to buy a house than they could drive a Ferrari. True deleveraging of mortgage debt has indeed taken place since that bubble burst, mainly through the mechanism of some 10 million homes going into foreclosure. It's no secret that credit has resultantly struggled mightily to return to the mortgage space since.     

Today though, Part II of this saga features an opposite imbalance that's taken hold. Car sales have come unhinged from that of homes and are roaring ahead at full speed, up 76 percent since the recession ended six years ago, more than three times the pace of home sales over the same period. It's difficult to fathom how car sales are so strong. Disposable income, adjusted for inflation, is up a barely discernible 1.5 percent in the three years through 2014. Add the loosest car lending standards on record to the equation and you quickly square the circle. Little wonder that the issuance of securities backed by car loans is racing ahead of last year's pace. If sustained, this year will take out the 2006 record. At what cost? Maybe the record 16 percent of used car buyers taking out 73-84 month loans should answer that question.    

To be sure, car loans are but a drop in the $57 trillion debt bucket. The true overachievers, at the opposite end of the issuance spectrum, have been governments. The growth rate of government debt since 2007 has been 9.3 percent, a figure that explains the fact that global government debt is nearing $60 trillion, nearly double that of 2007. The plausibility of the summit to the peak of this mountain of debt is sound enough considering the task central bankers faced as the global financial system threatened to implode (thanks to their prior actions, mind you). In theory, government securities are as money good as you can get. Practice has yet to be attempted.    

The challenge when pondering $200 trillion of debt is that it's virtually impossible to pinpoint the next stressor. Those who follow the fixed income markets closely have their sights on the black box called Chinese local currency debt. A few basics on China and its anything-but-beautiful leverage. Since 2007 China's debt has quadrupled to $28 trillion, a journey that leaves its debt-to-GDP ratio at 282 percent, roughly double its 2007 starting point of 158 percent. For comparison purposes, that of Argentina is 33 percent (hard to borrow with no access to debt markets); the US is 233 percent while Japan's is 400 percent. If Chinese debt growth continues at its pace, it will rocket past the debt sound barrier (Japan) by 2018. As big as it is, China's debt markets have yet to withstand a rate-hiking cycle, hence investors' angst.    

My fear is of that always menacing great white swimming in ever smaller circles closer and closer to our shores. I worry about sanguine labels attached to untested markets. US high-grade bonds come to mind in that respect even as investors calmly but determinately exit junk bonds. Over the course of the past decade, the US corporate bond market has doubled to an $8.2 trillion market. A good portion of that growth has come from high yield bonds. But the magnificence has emanated from pristine issuers who have had unfettered access to the capital markets as starved-for-yield investors clamor to debt they deem to have a credit ratings close to that of Uncle Sam's. Again, labels are troublesome devils. Remember subprime AAA-rated mortgage-backed securities?

We've grown desensitized to multi-billion issues from high grade companies. Most investors sleep peacefully with the knowledge that their portfolios are indemnified thanks to a credit rating agency's stamp of approval. Mom and pop investors in particular are vulnerable to a jolt: the portion of the bond market they own through perceived-to-be-safe mutual funds and ETFs has doubled over the past decade. Retail investors probably have little understanding of the required, intricate behind-the-scenes hopscotching being played out by huge mutual fund companies. This allows high yield redemptions to present a smooth, tranquil surface with little in the way of annoying ripples. That might have something to do with liquidity being portable between junk and high grade funds - moves made under the working assumption that the Fed will step in and assure markets that more cowbell will always be forthcoming rather than risk the slightest of dramas unfolding. Once the reassurance is acknowledged by the market, all can be righted in the ledgers. It's worked so far. But investors have yet to even consider selling their high grade holdings. It's unthinkable.     It's hard to fathom that back in 1975 when I was a kindergartener, security markets' share of U.S. GDP was negligible. Forty years later, liquidity is everywhere and always a monetary phenomenon. That is, until it's not.

Nary are any of us far removed from a poor stricken soul who has suffered a fall from grace. In the debt markets, a "fallen angel" is a term assigned to a high grade issuer that descends to a junk-rated state. It could just as easily refer to any credit in the $200 trillion universe investors perceive as being risk-free. Should the need arise, will there be enough room on policymakers' boats to provide seating for every fallen angel? That is certainly the hope. But what if the real bubble IS the sheer size of the collective balance sheet? If that's the case, we really are gonna need a bigger boat.