In this article, I will discuss the findings posted in the IMF’s Global Stability Report and some of the latest economic statistics. The IMF’s report was shocking as it has graphs that look like what economic realists like John Hussman and David Stockman publish. When the bearish narrative leaks into government reports, you know the situation is dire as the government has a bias towards being positive. I consider the current period to be the ultimate test in intellectual integrity. If you don’t think stocks are expensive when the S&P 500’s price to sales ratio is the highest ever, you clearly ignore facts. The debt in the economy and valuations are making the decision to be bearish as easy as it will ever get.
The chart below shows the debt bubble I’m discussing. Low interest rates combined with index fund investing has distributed the bubble more evenly than the prior two bubles. Therefore, the median net debt to EBITDA of S&P 500 firms is near the all-time high. The mean debt to EBITDA isn’t at the level of the 1990s tech bubble because a few technology stocks pushed the average higher. The median is more important than the mean in this statistic because it reflects the percentage of firms which have too much debt. Although the mean isn’t important to judging the size of the bubble, it’s usually a good signal for when the economy turns. It has fallen in every recession besides the one in the early 1980s. It has had a few mid-cycle dips but usually when the dip continues a recession either happened or is about to happen. This makes the latest dip notable. It makes sense for the debt to EBITDA to peak after the recession starts because earnings fall during recessions. Recessions are caused by a deleveraging, so the ratio eventually falls.
The fact that the recession hasn’t started and the median debt is so large is disconcerting because the mini earnings recession of 2015-2016 will look like nothing when a real recession occurs. Finally, you can see the pause in the debt increase when energy is included because of the crash in oil prices in 2014 and 2015. Lately the debt has flowed back into energy as they have lowered their breakeven costs making it profitable to drill with oil in the low $50s.
The chart below shows the distribution of interest coverage ratios among firms of various sizes. As you can see, interest coverage ratios peak in the middle of the cycle as the debt level starts to increase faster than earnings. There is usually a sharp dip during recessions as earnings fall sharply. The smallest 25% of firms by assets are near the lowest interest coverage ratio in the past twenty years even before the recession has hit. If interest rates were to rise, this would get ugly as the bankruptcies among smaller firms would skyrocket. As you can see, the situation is already dire for firms within the smallest 5% of assets category. Cheap debt encourages large firms to buy up their smaller competitors. The weakest firms aren’t bought and they are left to compete with an even bigger firm which has more resources to create better products at lower costs.
There’s no need to have to imagine what higher interest rates would do to interest coverage ratios because that potential situation is shown in the chart below. The average coverage ratio will fall to below the rate seen in the 2008 financial crisis. This scenario is without a recession. If a recession and an increase in financing costs occurs simultaneously, there will be a bloodbath especially for smaller firms who are already feeling the heat as their margins are compressing.
Getting into the latest economic data, the American Trucking Associations’ advanced seasonally adjusted For-Hire Truck Tonnage Index fell 1% in March on a sequential basis. The chart below seems to hint that the trucking cycle is about to turn over. The index was up 0.7% in March year over year, but it was down 2.7% year over year in February. The index is down 3.6% from the all-time high in February 2016. Trucking represents 70.1% of tonnage carried by domestic freight transportation which means it’s one of the best barometers of economic activity. The economy has stalled out, but still isn’t crashing which is why I continue to say yellow flags are being waved instead of red ones.
The chart below shows the Citigroup economic surprise index compared to the thirteen week change in the ten-year bond yield. The two metrics are highly correlated which is why bullish investors must pay attention to the rally in the long bond in the past several weeks. It’s a response to the lack of a fiscal stimulus and the weakness in the hard data which has been released. Weak hard data is why the Atlanta Fed sees 0.5% GDP growth in Q1. The Citigroup economic surprise index includes both the hard and soft data which is why it has risen since the election. The economic surprise index is now barely positive. Weakness in the labor market will push it to the negatives. An interesting thought experiment is what would happen to the long bond if the economy fell into a recession. Would the ten-year bond yield fall below the lows of the summer of 2016 or would rates rise in a stagflationary economy? If you’re holding long bonds until maturity, you’re locking in low returns which is unacceptable. The long bond has become a trading vehicle in this financialized bubble economy.
The IMF is showing charts typically shown by David Stockman and John Hussman who many would call perma-bears. The current scenario shows who is a perma-bull because the economy is weak and stocks are expensive. Soon we’ll see who the perma-bears are because stocks will fall to more reasonable levels. Judging by the tonnage shipped by the trucking industry, a stock market crash may not be imminent. However, from my perspective if a crash occurs in 8 months, I still don’t want buy stocks now because I’m not a fan of picking up quarters on a highway.