By John Mauldin
Cut interest rates, increase liquidity, and otherwise shove capital into the private sector. This helps businesses hire more workers and raise wages. Then gradually remove all the stimulus as growth recovers.
This playbook truly fell apart in 2008. The system had so much debt that adding yet more of it didn’t have the desired effect.
Even dropping short-term rates to zero didn’t help because it was creditworthiness, not interest costs, that kept people and businesses from borrowing.
The Bernanke Fed’s answer was quantitative easing. It had an effect but not the intended one.
Instead of going to productive use, the new stimulus helped banks deleverage and public companies repurchase their own shares or simply buy their competition.
This pushed asset prices, i.e. the stock market, higher and made it appear recovery was underway. Unfortunately, the “recovery” was the slowest recovery on record.
All that cash eventually trickled through the economy to yield-starved investors, not people who would spend it on useful goods and services.
Why were they starving? Because the Fed was keeping rates low. They had little choice but to take more risk, which is what the Fed wanted them to do in the first place.
So they plunged money into venture capital, private equity, IPOs, emerging markets, and everything else they could find with potentially decent capital gains and/or yields.
The result was a massive wave of investment, some good and some, well, let’s just say based on hope and little else. And hope is not a solid investment strategy.
Some businesses that had good stories (the so-called unicorns) found themselves covered with cash from hopeful investors. These companies emulated the Amazon model by using money to buy growth without profit.
In the hopes of going public at some point and cashing in, they kept the game alive. Think Lyft. Investors wanted to believe the story they were investing in was true, so they watched and waited.
They’re still waiting. And here we are.
A 2018 study examined a database of 32,000 listed companies in 14 advanced economies to identify “zombie” businesses. By their broad definition, a company is a zombie if it is…
- At least 10 years old, and
- Had an interest coverage ratio below 1.0 for three consecutive years.
Note, these were not startup companies. All were at least 10 years old and still in business despite their inability to make any money.
A Bank of America Merrill Lynch study finds roughly the same thing: 13% of developed-country public companies can’t even cover their interest payments. They are either borrowing more cash to pay off previous loans, or issuing equity to hopeful (too hopeful) investors.
Now, there are perfectly understandable, human reasons for this.
Faced with a probable loss, lenders always face a temptation to “extend and pretend.” They convince themselves that another year or another quarter will let it turn into a sterling borrower who pays in full and on time.
And more often than not, the zombie company has a charismatic CEO or founder who can charm lenders.
While it’s easy to say these investors are making poor decisions, they’re not doing it in a vacuum. They’re trying to earn positive returns in a world where central bankers have made positive returns an endangered species.
This means everyone is operating with distorted information and incentives. We’re in a hall of mirrors, so no surprise some people crash into the glass.
None of this is “natural.” It’s not the free market gone wild. It is the result of a manipulated market. The manipulators are what went wild. Sadly, they’ve only just begun….