Juggling Dynamite

Danielle was a guest with Jim Goddard on Talk Digital Network, discussing recent developments in the world economy and markets.

You can listen to an audio clip of the segment here.

Companies pushing up share prices with buybacks (while their executives sell personal holdings into the flow) have greatly supported stock prices (and executive compensation) over the past decade. The party was planned to continue in 2023 with a record $360 billion in buybacks authorized year-to-date. But, as usual, something unexpected happened on easy money street: leaping borrowing costs, slower sales and falling profits.

We’ve long observed that companies (like households) are pro-cyclical; they buy equities the most when valuations are frothy and the least when deeply discounted.

Recent Goldman Sachs data shows that executed buybacks were -20% year-over-year in the fourth quarter of 2022. And despite record authorizations for 2023, they’re also running negative year-over-year in the first quarter. Buyback trends rise and fall with the ease of credit and typically lead capital expenditures, research and development.

The decline to date is illuminating since we are just entering the second year of this monetary tightening cycle, and it’s not until year two that the bulk of policy effects are felt. Many loans and bonds were issued with fixed terms when rates were at record lows. So, the cost of carrying those debts has yet to jump. That’s coming next.

A recent study of non-financial companies in the S&P 500 found that the weighted average interest rate on their debt was 2.65%, much lower than companies have paid historically and a fraction of what they can borrow at today.

A higher cost of capital is better for encouraging efficiency, sober risk management and smarter allocation decisions, but it will be hard on profits and lofty asset valuations first. See, WSJ, Higher rates are coming for US companies:

In 1990, Federal Reserve data show that the interest paid by nonfinancial corporate businesses as a share of their outstanding debt, a proxy for the average interest rates they were paying, came to 13.3%. By 2021—the last year with available data—that had fallen to 3.6%, marking the lowest level since the late 1950s. Over the same period, long-term yields on Baa-rated corporate debt fell from 10.4% to 3.4%, according to Moody’s.

…So companies could have some difficult choices to make in the years ahead. Some will likely decide to reduce their debt loads, choosing either to curtail investment and expansion efforts, or to finance those efforts by other means, such as issuing equity. Others will refinance their maturing debt at higher rates, with higher borrowing costs weighing on earnings as a result. Neither of those possibilities seem all that pleasing to stock investors.

Over the past year, bonds and mortgage-backed securities dropped in value as central banks hiked base rates in the banking system—that’s interest rate risk. The sound ones also rebound in value as central banks pause and then start cutting rates again.

But that doesn’t mean these instruments all have the same risk profile. Government bonds are transparent securities backed by the taxation ability of their issuers. They are liquid, priced to market daily and mature at face value on a set date.

As became painfully evident in the subprime meltdown of 2007-2008, other bonds/loans and mortgage-backed securities are only as sound as the borrowers behind them. And most of the unrealized losses on lender balance sheets today are in mortgage and other asset-backed securities (blue and grey bars below), not Treasuries (in green), courtesy of the Wall Street Journal, see, Where Financial Risk Lies, 12 charts.

After 12 years of easy money, there are a lot of weak players and sketchy loans out there, especially in the wildly overbuilt and overvalued commercial real estate sector. There, venture capital and private equity firms have been feasting like fungus in the opacity of values marked to fantastical ZIRP and TINA-inspired estimates for a decade. Eventually, the reality of lower market prices will have to be accounted for.

As a liquidity crunch spreads, redemption requests rise amid payment defaults and tumbling property values. Extend and pretend are running out of options. See Bloomberg, SVB Collapse could mean a $500 billion Venture Captial haircut. Here’s a taste:

Some VC and private equity firms are turning toward strategies to “extend” and “pretend,” meaning they would hold on to assets or prop up capital to avoid true price discovery, Patankar added in a Friday interview. Examples of this include net asset value loans that let general partners borrow against a pool of portfolio companies within a fund, GP-led secondary structures where a fund sponsor sells one or more assets from a fund it already manages to a new fund, and alternative financing via private credit.

But those methods can only delay but not deny the ultimate fundamental problem of “untenable” and “unrealistic nature” of venture valuations, he said. “There are enough zombie companies with frothy valuations that need restructuring, price discovery and of course re-tooling of their business models to a world of tighter credit, subdued revenue and higher rates,” Patankar said.

CNBC’s Diana Olick reports on news from the commercial real estate sector. Here is a direct video link.