MASSIVE MISALLOCATION OF CAPITAL & MALINVESTMENT SUPPORTING ZOMBIE CORPORATIONS
One especially sensitive topic that has gotten renewed prominence in financial circles in recent weeks, is the fate of "zombie" companies in a low yield world, where the yield is starting to rise uncomfortably fast.
It started last December, when the IMF published a blog discussing the "Walking Debt: China's Zombies" (a topic we first covered in October 2015 in "More Than Half Of China's Commodity Companies Can't Pay The Interest On Their Debt"). Slamming China’s “zombies”, the IMF said they "are non-viable firms that are adding to the country’s rising corporate debt problem, and are bad business. Zombie firms are highly indebted and incur persistent losses, but continue to operate with the support of local governments or soft loans by banks—adding very little value to economic prospects."
Then, last week, as part of Deutsche Bank's series on the impact of rising rates in a low rate world, Jim Reid also looked at "The persistence of zombie firms in a low yield world" which looked at the productivity and deflationary impact from keeping undead companies operating way beyond their expiration date.
If the survival of zombie firms is a drag on productivity growth, then one would expect to see further evidence of falling business dynamism. That can be seen in the decline in the share of young firms in the economy, halving to 8 per cent of all US firms since late 1970s. If bankruptcies represent an essential process of capitalism's creative destruction, that too has slowed, and are now the lowest they've been since at least 1980 in the US.
Today, completing the "zombie trifecta" is Bank of America's Barnaby Martin who looks at a day in the life of quasi-insolvent companies one year ahead, in a world in which the ECB's bond buying is a thing of the past:
Although some months away, 2019 will be the first time in four years that European markets will have to manage without the helping hand of ECB asset buying. And Chart 8 highlights the immediate challenge for markets in this new era. The total amount of fixed-income redemptions in Europe (sovereigns +IG credit + HY credit) will jump by 20% next year to €1.1tr. Private investors will likely have to swallow a lot more bonds next year.
To be sure, there is an easy way to find buyers for the €1.1 trillion in debt: just push the yields much higher. Alas, here lies the rub, because the upcoming jump in interest expense is precisely the silver bullet that will lead to a mass zombie genocide, or as Martin puts it, "we fear another issue in a world where central bank asset buying has ground to a halt" - that issue is what happens when "misallocation of capital" comes home to roost.
In Martin's take on the "zombie problem", the core issue is that the record low yields unleashed by the ECB's QE have resulted in capital allocation decisions that would have been impossible under normal conditions:
QE has driven such a powerful reach for yield over the last few years – whether it be from high-grade into high-yield, from senior bonds into subordinated debt, or from eligible assets into non-eligible ones – that levels of spread compression have been pulled to incredibly low levels. And when the riskier appear riskless, capital allocation decision cannot function properly.
As he has done previously, Martin then draw another parallel of this cycle to the low-volatility, reach for yield 2004-2007 cycle, and "while the CDO phenomenon today is a far cry from what it was a decade ago, other facets of the market feel eerily similar."
Take for instance the LBO cycle – something that dominated corporate headlines between 2005 and 2006. Fast forward to today, and as Chart 10 overleaf shows, big public to private deals seem to be back again in Europe, given huge private equity cash balances. And the outlook for private equity activity in Europe looks promising given no change in Europe’s tax treatment of debt, unlike in the US.
And ironically, the company that kick-started the European LBO cycle in 2005 – namely TDC – is the company that is again kick-starting the LBO cycle this time around.
Needless to say, the 2006 LBO cycle did not have a happy ending for many. This time it's very much the same: while on one hand, "as money is increasingly crowded into riskier parts of the market, the fundamental weaknesses of companies can be conveniently glossed over." However, "when central bank asset buying is no more, the risk is that the market undergoes a collective reassessment of valuations – in other words we think dispersion in credit will materially jump in ’19."
Which brings us to a face to face encounter with Europe's zombies, a topic that the Bank of America strategist has touched upon previously, most recently last July, when he argued that Europe has a conspicuously large number of “zombie” companies – defined as those with interest coverage ratios less than 1x. He was right, and Europe's zombies have Mario Draghi to thank.
Last July, 9% of Stoxx 600 companies were zombies. In our view, a combination of easy monetary policy and bank regulatory forbearance had allowed these issuers to “live another day”, when in normal times they would have defaulted.
What happens to Europe's zombies next? Martin thinks much can be learned regarding how things change when QE is no more, by looking at the experience of the US high-yield market post the end of the Fed’s asset buying.
Chart 12 shows the 6m change in the Fed’s balance sheet versus US high-yield energy defaults. Interestingly, as the rate of growth in the Fed’s balance sheet slowed to zero in March 2015, US high-yield energy defaults began to rise. The growth of US high yield energy debt had been tremendous between 2012 and 2014 – with the market almost doubling in size – as the shale phenomenon took off. Overlending in the sector thus became problematic.
And while other risk-off factors materialized in 2015 to pressure US energy defaults – such as China weakness and a falling oil price – we find it nonetheless revealing that when the Fed stopped QE, leveraged capital structures in the US credit market began to suffer. “Misallocation of capital” had come home to roost…
So what does using the 2015 energy crash framework reveal about the fate of “zombies” in Europe? As Chart 13 above shows, there is a clear correlation between the rate of change of the ECB's balance sheet and the number of EU zombie companies.
An interesting relationship unfolds, in our view, with similar conclusions to the US example above. We find a reasonable link between the rate of growth of the ECB’s balance sheet over time and the growth rate of European zombies.
Or simply said, "when the ECB has been supporting markets through periods of QE, zombies have been growing in Europe, as companies have used the cheap liquidity to “live for another day”. But when the ECB has been shrinking its balance sheet (LTRO roll-offs etc.) the number of zombie companies has declined – and the default rate has consequently risen."
Martin's conclusion: credit investors should brace themselves for not only volatility, but a surge in defaults in 2019:
In a year where ECB balance sheet growth will likely be over, the chart below implies that the liquidity support for zombie companies will fall away. And other things being equal – just as was the case in late 2011/early 2012 – the number of “zombies” will decline through the process of higher default rates in Europe.
And so we’re left with a paradox…that in 2019, just as the ECB endorse the strengthening of the Eurozone recovery by stopping QE, Europe may experience a “flash” jump in default rates, as “zombies” disappear. “Misallocation of capital” may again come home to roost…
Martin is half-right: what 2019 will expose is that there never was a recovery in the first place, but a mirage created from the vapors of monetary printing presses, as trillions in new money were created out of thin air to prop up the illusion of a recovery.
Finally, while Martin is focused on Europe, he may want to also take a look at the US, because while the IMF may have recently turned its attention to zombie companies, it was the BIS which one year ago warned that no less than 20% of US corporations are "challenged" and at risk of default once rates start rising. Which simply means that thousands of defaults are imminent once rates truly spike after the next central bank policy mistake.