I will be sharing with you insights from John Mauldin's The...

I will be sharing with you insights from John Mauldin's The Great Reset in a series of posts [ highlights in Bold are mine]

Post #1

Whatever you want to call it, a worldwide debt default is likely in the next 5–10 years. We are rapidly approaching the point where there is no simple way to avoid it—the only question now is how we will manage the collapse. Investigators of transportation disasters, crimes, and terror incidents usually create a chronology of events. We do something similar in economics when we look back at past recessions and stock market crashes. In hindsight, the causes always seem obvious, so why don’t people see them coming? Well, some people do see the crisis coming, but no one listens to them. The investing crowd’s excessive exuberance and the willful ignorance of policy makers and pundits drown out their warnings. That’s what I have been wrestling with for the last five years. I see this crash coming, and I’m afraid most people will be caught in it unprepared. People tend to believe the future will play out more or less exactly like the past. But it won’t—so we have to restructure our beliefs and portfolios to make sure we get as much of our wealth as possible to the “other side” of this crisis. Once we’ve made it through, we will see the greatest bull market of our lives. We just have to get there with our assets intact. The precise route is uncertain, but the destination is not. Consider this report a kind of “road map” to orient you for the journey

Corporate Credit Crisis Key Takeaways:

• The Fed’s artificially low rates broke the pattern of economic cycles.
• Today’s economy is driven by credit cycles, not business cycles.
• The most likely trigger for the next recession is a collapse in high-yield corporate debt due to a lack of liquidity.
• Dodd-Frank discouraged big banks from making markets in corporate high-yield debt, reducing liquidity.
• Hedge funds filled the liquidity gap, but since they are not market makers, liquidity could quickly disappear.

In 1999, I predicted the tech bubble would eventually spark a recession. Timing was unclear because stock bubbles can blow way bigger than we can imagine. Then the yield curve inverted, and I said recession was certain. I was early in that call, but it happened.

In late 2006, I began warning about the subprime crisis, and shortly afterward the yield curve again inverted, which warranted another recession call. Again, I was early, but you see the pattern.

Now let’s fast-forward to today. Here’s a quote from my friend Peter Boockvar that drew an enormous amount of interest: “We no longer have business cycles, we have credit cycles.” Let’s cut that small but meaty sound bite into pieces. What do we mean by “business cycle,” exactly?

A growing economy peaks, contracts to a trough (what we call “recession”, recovers to enter prosperity, and hits a higher peak. Then the process repeats. The economy is always in either expansion or contraction. This pattern broke down in the last decade. We had an especially painful contraction followed by an extraordinarily weak expansion. GDP growth should reach 5% in the recovery and prosperity phases, not the 3% (at best) we have seen since 2008.

Peter blames the Federal Reserve’s artificially low interest rates. Here’s how he put it in an April 18 letter to his subscribers: To me, it is a very simple message being sent. We must understand that we no longer have economic cycles. We have credit cycles that ebb and flow with monetary policy. After all, when the Fed cuts rates to extremes, its only function is to encourage the rest of us to borrow a lot of money and we seem to have been very good at that. Thus, in reverse, when rates are being raised, when liquidity rolls away, it discourages us from taking on more debt. We don’t save enough. The problem is that over time, debt stops stimulating growth.

In the following chapters, you will see that it takes increasing amounts of debt for every point of GDP growth, both in the US and elsewhere. Hence, the flat-to-mild “recovery” years. Debt-fueled growth is fun at first but simply pulls forward future spending, which we then miss. Debt also boosts asset prices—that’s why stocks and real estate have performed so well. If financing costs rise and buyers lack cash, the asset price must fall. And fall it will. Further, since debt drives so much GDP growth, its cost (i.e., interest rates) is the main variable defining where we are in the cycle. The Fed controls that cost—or at least tries to—so we all obsess on Fed policy. And rightly so. Now we’re entering the much more dangerous reversal phase in which the Fed tries to break the debt addiction. We all know that never ends well.

Corporate Debt Disaster

In an old-style economic cycle, recessions triggered bear markets. Economic contraction slowed consumer spending, corporate earnings fell, and stock prices dropped. That’s not how it works when the credit cycle is in control. Lower asset prices aren’t the result of a recession. They cause the recession. That’s because access to credit drives consumer spending and business investment. Take it away and they decline. Recession follows. If some of this sounds like the Hyman Minsky financial instability hypothesis, you’re exactly right. Minsky said exuberant firms take on too much debt, which paralyzes them, and then bad things start happening. I think we’re approaching that point.


The last “Minsky Moment” came from subprime mortgages and associated derivatives. Those are getting problematic again, but I think today’s bigger risk is the sheer amount of corporate debt, especially high-yield bonds, which will be very hard to liquidate in a crisis. Corporate debt is now at a level that has not ended well in past cycles.

The debt/GDP ratio could go higher still, but I think not much more. Whenever it falls, lenders (including bond fund and ETF investors) will want to sell. Then comes the hard part: to whom? You see, it’s not just borrowers who’ve become accustomed to easy credit. Many lenders assume they can exit at a moment’s notice.

We have two related problems here:
• Corporate debt issuance, especially high-yield debt, has exploded since 2009.
• Tighter regulations discouraged banks from making markets in corporate and HY debt.

Both are problems, but the second is worse. Experts tell me that Dodd-Frank requirements have reduced major banks’ market-making abilities by around 90%. For now, bond market liquidity is fine because hedge funds and other non-bank lenders have filled the gap. The problem is they are not true market makers. Nothing requires them to hold inventory or to buy when you want to sell. That means all the bids can “magically” disappear just when you need them most. Worse, I don’t have enough exclamation points to describe the disaster when high-yield funds— often purchased by mom-and-pop investors in a reach for yield—all try to sell at once and at firesale prices to meet redemptions.

In a bear market, you sell what you can, not what you want to. The picture will not be pretty. To make matters worse, many of these lenders are far more leveraged this time. They bought their corporate bonds with borrowed money, confident that low interest rates and defaults would keep risks manageable.

In fact, according to S&P Global Market Watch, 77% of corporate bonds that are leveraged are what’s known as “covenant-lite.” Put simply, the borrower doesn’t have to repay by conventional means. Sometimes they can even force the lender to take more debt. As the economy enters recession, many companies will lose their ability to service debt. Normally, this would be the borrowers’ problem, but covenant-lite lenders took it on themselves. This means the macroeconomic effects will spread even more widely. Companies that can’t service their debt have little choice but to shrink. They will do it via layoffs, reducing inventory and investment, or selling assets. All those reduce growth and, if widespread enough, lead to recession. The problem is that much of the at least $2 trillion in bond ETF and mutual funds isn’t owned by long-term investors who hold to maturity. When the herd of investors calls up to redeem, there will be no bids for the “bad” bonds. But funds are required to pay redemptions, so they’ll have to sell their “good” bonds. Remaining investors will be stuck with an increasingly poor-quality portfolio, which will drop even faster.

Those of us with a little gray hair have seen this before, but I think the coming one is potentially biblical in proportion