(Excerpted from the May Global Market Perspective)
The "biggest U.K. retail collapse since Woolworth's Group in 2008" (Bloomberg, 4/25/16) speaks powerfully about the future. In April, BHS Group, which has survived every economic downturn since opening its first south London store in 1928, filed for bankruptcy and put 11,000 jobs at risk. As one strategist recently told Bloomberg, "We've had more corporate debt than ever, and more leverage than ever, which increases the potential for greater pain." (Bloomberg, 4/6/16) Clearly, today's economy presents a deflationary puzzle that even the most stalwart businesses have yet to figure out.
There are a few more underappreciated aspects about deflation in today's environment. While inflation merely damages the bond market by devaluing principal and interest payments, deflation virtually destroys the market by generating widespread defaults. And because optimism remains elevated, fixed-income investors remain wedded to the idea that widespread defaults are impossible in the 21st century economy. This dangerous belief is about to steamroll huge segments of the economy.
Here's a picture of the mountain of UK and European debt that has been growing steadily since 2008. Eurozone and UK debt totals held largely flat at 50% to 60% of GDP throughout the early 2000s, but the 2008 financial crisis changed everything: Debt-to-GDP ratios have now pushed above 90%, as governments everywhere borrowed heavily to prevent the inevitable contraction. What goes up must come down, however, and this Bloomberg article recognizes that the looming reversal will be one of the most agonizing yet:
The Coming Default Wave Is Shaping Up to Be Among Most Painful
--Bloomberg, April 6, 2016
In fact, three factors suggest that the coming debt crisis will exceed that of 2008, according to the article:
For one, falling interest rates during the last credit cycle allowed many companies to refinance their debt -- in lieu of defaulting. Today, "those Band-Aids are no longer available," explains the managing director of a distressed-debt consulting firm.
Second, leverage levels are higher now than they were in 2008. In other words, bond issuers hold more debt relative to available assets. So when financial conditions force these companies to liquidate, a shrinking pile of proceeds must now cover a growing pile of liabilities.
Lastly, recovery rates are dropping, meaning that investors get back less principal when a bond issuer defaults. In the past two years, recovery rates have fallen from 44 cents to 29 cents on the dollar, according to Bank of America Merrill Lynch.
Bank of America Merrill Lynch also says that recovery rates could hit the mid-teens before this credit cycle ends, but we think rates will get much closer to zero. The thing is, once investors become suspicious about debt, that concern becomes nearly impossible to dislodge.
