Investors are living off of a narrative these days, the narrative that the Federal Reserve will continue to underwrite the stock market and if the stock market remains strong, corporations will remain solvent and the economy will, in time, recover and people will go back to their old jobs.
Joe Rennison writes in the Financial Times that
major market players are still preparing for a rally in corporate debt prices next year, with rising risks outweighed by expectations of continued support from the Federal Reserve following the central bankâ€™s historic decision to begin buying corporate debt in March.â€
Actually, the â€œexpectations of continued support from the Federal Reserveâ€ have been built up over a longer period of time than is alluded to in this statement.
This reliance on the Fed actually began back in the days of the Great Recession as then Fed Chairman Ben Bernanke devised a Federal Reserve policy to combat the ongoing economic downturn.
Mr. Bernankeâ€™s plan was to use the Federal Reserve to generate a â€œwealthâ€ effect, one resulting from rising stock prices, that would stimulate consumer spending, which would generate rising economic growth.
And, Mr. Bernanke and the Federal Reserve were very, very successful.
Mr. Bernanke And The Fed Succeed
The economic largesse of the Fed got the economic recovery going and this was followed by three rounds of quantitative easing. Then, Federal Reserve officials made certain that the financial markets knew that going forward the Fed would work to err on the side of monetary ease in an effort to avoid any possibility of the economic recovery reversing itself and diving down into another recession.
This thrust of monetary policy convinced financial markets that the stock market would continue to rise and that investor could put more and more money â€œsafelyâ€ into the stock market to ride market on to more and more historic highs. Confirming this â€œsafetyâ€ along with higher returns, investors moved massive amounts of funds from â€œvalue investingâ€ efforts to â€œpassiveâ€ investment vehicles. The Federal Reserve was very successful in generating the â€œwealthâ€ effect Mr. Bernanke was looking for.
Those that followed Mr. Bernanke followed Mr. Bernankeâ€™s lead. In most cases, the Fed support for the stock market continued, but any time it appeared as if the Fed might be altering its focus the stock market tended to waver a little. That is, until the Fed came back into to market to confirm that it was still operating to err on the side of monetary ease.
In terms of the current situation, Mr. Rennison writes that
while the Fed and other central banks have curtailed the severity of the impact from coronavirus, helping open up debt markets to keep companies alive, the concern is that it has simply left businesses comatose on central bankâ€™s life support.â€
Cash Is All Over The Place
As a consequence, U. S. companies, in 2020, borrowed a record $2.5 trillion in the bond market. Debt leverage has risen to an all-time high for â€œhigher-rated, investment grade companies.â€
Consequently, â€œU. S. Companies Are Sitting On The Largest Pile Of Cash Ever.â€ And, the number of zombie companies, those whose interest payments are greater than their profits, are close to an historic peak after rising for three years in a row.
Mr. Rennison also notes that the feeling is that corporations will not use this built-up cash position to be used from stock buybacks. The cash is remaining on balance sheets, analysts argue, and will be used to reduce debt loads as the economy recovers. The debt was raised at historically low interest rates and to reduce fears of a liquidity crisis. The cash now on the corporate balance sheets, it is argued, will go to pay off older debt that have a higher rate of interest.
Thus the Fed actions not only avoided a â€œliquidityâ€ crisis, but if this scenario works out, it will be the case that the Fed actions also prevented a â€œsolvencyâ€ crisis. Wow!
The problem will be, if we get to that state, and the corporations do use their cash hoards to pay of some of the debt, they will not be using those funds to invest in physical capital, something that is needed to get the â€œrealâ€ economy booming again.
And, in such situations, the zombie companies may not be able to borrow more from banks or other sources, because of their leverage situation.
But, this would be very bad news for the economy. It would mean that the coming economic recovery would tend to be on the mediorce side since it would not get much help from any increase in corporate physical investment.
Another View Of How Credit Inflation Works
Here is another example of the results of the policy of credit inflation that the Federal Reserve has contributed to for around sixty years. I have written a lot about the policy of credit inflation and I donâ€™t have space to get into it deeply now.
The effort to keep the stock market rising is a part of the Fedâ€™s effort to keep credit flowing into and through the economy. The expectation that credit will continue to flow over time has led investors to move stimulus funds into the financial circuits of the economy and not into areas that would generate real economic growth. Thus, we get asset price inflation, but not consumer price inflation in the real economy.
In the current case, we see that the Fedâ€™s largesse has gone into the financial engineering of the corporations and not into real economic activity. As a consequence, one can expect when things seem to get better, the financial stimulus will stay in the financial circuit and not leak into the purchase of real capital expenditures. So much for economic growth.
The Narrative About The Fed
So, we are not talking about real economics here. We are talking about the narrative that investors have built up about what the Federal Reserve is doing and what the Federal Reserve intends to do. As I have written about many times, this is why we talk about the current environment as being on of â€œradical uncertainty.â€
The economyâ€¦ and the stock marketâ€¦and the bond marketâ€¦all rest in the picture that investors draw in the narrative about the Federal Reserve that has been built up in recent years. Thus, the economyâ€¦ and the stock marketsâ€¦ and the bond marketâ€¦will live or die off of how this narrative unfolds over the coming months.
The Federal Reserve has brought us here. In one way or another the Fed will play a role in how me move on. It will be, I believe, an interesting ride.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.