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Terminal Value

Financial Market Forecast – 2022

Doug Utberg

Business Growth Authority | Technology Strategy & Resourcing | Cost Optimization Expert | Business Process Architect | Financial Strategist | Founder - Terminal Value Podcast
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What we’re going to be talking about today on a forecast Friday edition is the big R word that seems to be in the news. And that is recession. In other words, is a recession coming? Okay, the short answer is yes, and I’m going to put a copy out on that. Is that because no matter where you’re at, a recession is always coming, just like an expansion is always coming. The way economies work is that they move in cycles of expansion and recession. But the key question that people want to know is, is a recession coming soon, more specifically this year? And my answer to that, I’m going to go on a limit here. But my answer to that is most likely. And what I want to do is I want to walk through the reason why I believe that with you, the Listers.

Okay. So why do I think that a recession is coming this year? So there’s a couple of factors that go into that. Number one is the interest rates. This is in the United States. I’m speaking from the United States perspective, but interest rates have been low for a very long time. And so what’s happened is a couple of things have happened. So number one is that with those low interest rates, many businesses have become accustomed to those low interest rates. And that has baked into their value, their market valuations, their bond valuations, et cetera. And so what that ends up meaning is that when a company’s plans are based on low interest rates, an increase in interest rates will result in a higher cost of capital, which will result in less products becoming feasible, which is going to put a damper on the future outlook also increases in interest rates. What those will typically do is drive up compared to bond prices. And what ends up happening with bond prices is that the price of a bond is inversely proportional to the interest rate. So in other words, if interest rates are low, bond prices will be high, interest rates are high, bond prices will be relatively low. And so what usually ends up getting quoted on a bond price is what they call the yield to maturity or the yield. And so that’s saying, if you bought it now and held it to maturity, what is the compounded rate of return that you will earn on that money? Because it’s just usually a cleaner way to quote bond prices. But anyway, with interest rates are going up, what’s going to end up happening is that that is going to start putting downward pressure on the pricing for corporate debt, which means that it’s going to be more expensive to refinance, as I used to say in commercials that I watched late at night as a kid. But wait, there’s more. What’s happening also is that we have inflation. Anybody who has bought anything in the last few months knows over the last two years knows that there is inflation. Of course, this is also being accelerated by the by Russia’s war with Ukraine, which is constraining energy prices in our case. Right.

You have two different factors going on for inflation. Factor one is that the Federal Reserve has been expanding the money supply and or they’ve been expanding the money supply through increasing the amount of debt on their balance sheet for a very long time. There is a lot of money floating around in the economy that’s the monetary side of inflation. Factor two is that there have been supply chain shortages for about almost two years now, and those are being exacerbated by the Russia Ukraine war. So now you have both a flood of new capital in the market and a constraint in availability, which has resulted in a lot of inflation in a short amount of time. And so the question is, is it short term or long term? Now people who say that prices are going to revert fairly quickly, I don’t really know what they’re basing that on. I see no sign that the inflation is going to let up. Okay. Well, so now what ends up happening with that? Well, the only way that you are going to get that inflation to let up is going to be if you start constraining the amount of financing that is available to drive this velocity of transactions. And the way the government typically does that is by increasing interest rates, increasing short term interest rates, and then the Federal Reserve will start then what the Federal Reserve will start doing is the Federal Reserve Reserve will start doing open market activities to pull capital off out of the markets and back onto and a pull capital out of circulation so that there is less money chasing around after all these goods and services.

Okay. Well, there’s a few things that happen with all this. Number one,

with inflation going, that means that the only way the Fed or the government can really get inflation back under control is that they’re going to have to increase interest rates and borrowing costs quite a bit.

This is going to be really tricky, though, because there’s a few factors in play. One factor is that one out of five publicly traded companies, probably more you’re probably a larger number if you look at private companies. But one out of five publicly traded companies does not currently produce enough earnings to pay more than the interest on its debt or to pay down its debt. This is referred to as a zombie company. Well, as interest rates are going up and these zombie companies have to refinance their debt, many of them are going to be headed toward default because they will get into what’s called a debt spiral. And a debt spiral happens when the amount of interest that a company owes exceeds the amount of its pre tax earnings or the amount of what’s called EBIT or earnings before interest and taxes. And so in order to continue an operation, the company has to take on more debt. This is the proverbial College student living on credit cards, right. You can’t pay your credit card bill. So you take out another credit card and you charge this month’s bill on the new credit card. You can’t pay your next credit bill, say take out another credit card and you charge that month’s bill on the new credit card. And eventually you get to where nobody will loan you money anymore, and you end up going bankrupt at a young age and learn painful financial lessons. Now, fortunately, I didn’t go through that personally. But that’s the stereotypical example. That’s kind of like how a debt spiral works.

So as more companies get pushed into debt spiral, you’re going to start seeing bond defaults. And when there are bond defaults, you’ll end up having once those bond defaults happen, you’re going to end up seeing two big things that impact financial markets. Number one is that with interest rates going up and debt refinancing at higher rates, we will see downward pressure on bond prices, which right now bond prices are extremely high or extremely high historically, because interest rates are so low, those are going to be coming down naturally. But if you start seeing defaults now, you’re going to see a risk premium come back in. So for people who have not heard of this phrase before, a risk premium, when you’re talking about financial assets, particularly bonds, is saying that if you have something like a treasury that is assumed to be risk free, now, in reality, there is still an inflation risk because inflation can erode the purchasing power of the capital from the bond. But as far as repayment is concerned, if you have a treasury, the chance that you will not get paid back is zero. So that means if you have a non treasury instrument, your probability of not being paid back is some number higher than zero. Now, for example, let’s say that you have let’s say that you have bonds for someone like Google or Apple, chances of you getting paid back is really high. That’s the reason why they have an extremely high credit risk. Well, here so what ends up happening is that the interest rate that gets the interest rate that the market sets for these different types of bonds is based on what it incorporates, what they call a risk premium. So in other words,

when there is an increased risk of default, there is a higher interest rate, higher interest rate that needs to get charged.

Well, one of the signs that you are in what I would call an irrational expansion is when the risk premium compresses. So when the bond yield difference between, say, a higher risk asset, like what they call high yield debt. Back in the 80s, those are called junk bonds, but now they refer to a high yield investment versus investment grade bonds versus Treasuries when the yield difference between those two starts getting smaller. That’s called a risk premium compression. Well, what will happen is as soon as the market shifts to where they’re afraid of default repayment, you’ll have what they call flight to quality, which means that there will be capital that goes out of these higher risk instruments into lower risk instruments like Treasuries. So what that means is that

the price compression for something like Treasuries would probably be a little less, but the price compression for these riskier instruments is going to be much higher.

Now, this is going to have a number of different effects. One effect will be for people who are in, say, who have pensions. This is going to put a pinch on pension funds because pension funds tend to have a significant debt allocation because of its perceived lower risk. And then, of course, other things that are going to happen is that as a number of hedge funds, mutual funds, et cetera, that are carrying these financial assets, as they start experiencing these price pressures now, they are going to have to be adjust their portfolio in order to retain their liquidity ratios or in order to have you have a certain amount of liquid assets. So then that is going to put cell pressure on the stock side. And in addition to that, one of the other things that you’re seeing as far as stock and equities is that there is going to be a constraint on demand because inflation always pushes, always creates a headwind for additional demand. Now, of course, also bear in mind that the current stock market valuation, relative to earnings per share, is among, if not at the highest it’s ever been. So what that means is that there is a heavy amount of stock market value that is speculative in nature, as opposed to being based on fundamentals. And one of the things that we know is that, as they say, trees don’t grow to the sky. So what that means is that at some point growth levels off. And so whenever you have high valuations, high valuations are always based on an assumption of high growth. But high growth cannot be maintained indefinitely. In the 1990s, going into the.com bubble and birth, there were high growth expectations. It didn’t happen in 2006, 2007, going into the housing boom, there were high growth expectations that were dashed by the financial crisis. Right now, there are ridiculous growth expectations that are being driven by technology, by crypto, by other things like that. And it is very likely that those growth expectations are not going to be met. At some point when those growth expectations are not met, there will be a very material sell off of equities of stocks well, one of the things that you have to bear in mind is that a number of either individuals or institutions are carrying what are called margin accounts and a margin account is where you are borrowing a certain amount of the money that you are trading on the stock markets. Well, as the total market price goes down, you end up having what’s called a margin call. So in other words, if I’m a broker and I’m loaning new stock on margin and then the stock price starts going down, that’s where I say, hey, look, you need to sell some of your other assets so that I can get paid back. I am calling in my loan, you have to pay me back now. So then what ends up happening is when you have margin calls, you get into situations where you have what’s called force liquidation and a

forced liquidation is going to be where people have to sell their stocks in order to pay back the margin loans.

Well, in the event that all of these factors hit at once, which is pretty likely, then what you could start seeing happening is that bond prices start going down because of interest rates and at the same time because the zombie company defaults because of inflation and then because of forced deleveraging, you could also see equity prices start going down in a self reinforcing cycle that will ultimately result in some kind of bottom. So now the question is going to be, okay, what does all of this mean? Now, this is the part where I’m really conjecturing because I’m generally speaking, I’m bad at predicting the future. I have predicted what I’m currently estimating to be coming for a number of years now and the market just kept rocketing up and I felt really stupid. I am seeing many signs that the current expansion is running out of steam.

Now let’s take a look at the public debt and total debt portion of this equation. At the time of this recording, there is roughly $30 trillion of public debt outstanding. Okay, well, $30 trillion of public debt. What does that mean? Well, that means that if there is a 5% average interest rate, that your average interest rate on that debt, which right now it’s not that high. It’s considerably lower now. But let’s just say that the average interest rate on that public debt ends up getting to 5% before this whole thing is over. By the way, the last time we had inflation like this, it took an average interest rate much higher than that. But if you get an average interest rate of that means you get to one and a half trillion dollars per year of interest expense payable by the government. That’s a lot of money. Like a lot of money. And so the question is going to be where is the government going to get that kind of money? Most likely they would need to get it through. They would ordinarily get it through continued monetary expansion. The problem is that if they expand the money supply to get the money in order to pay the interest on the debt, they will just continue stoking inflation. So that would mean that they would either have to cut spending or they would have to increase taxes, both of which are things the government generally doesn’t like to do. So now let’s take it another way and look at the roughly $90 trillion of total debt outstanding. Okay. Well, so in this case, if you have, say, about a 5% average rate on that debt, the total debt I’m sending is probably a little closer to 5%. 5% of 90 trillion is going to be four and a half trillion dollars of interest per year. So that means that four and a half trillion dollars. I think the economy is right. About 20 trillion ish. So that means that you’re going to have over one fifth of all economic output is going to need to go to pay interest on debt. Well, if that number gets higher than 5%, which it could let’s say that it gets up to 10% like it did in the late 70s, early 80s. Now that number goes to 9 trillion. And this gets scary because 9 trillion is like about what, 45% of the $20 trillion outlet of the $20 trillion total annual GDP for the US. When you start getting to numbers that high, that’s where you get defaults. That’s where you’re going to start seeing broad defaults on debt obligations by consumers, by companies, etc. E. And when you start seeing those broad defaults, that is what drives financial markets into freefall. Now, I don’t know that that’s what’s going to happen, but I do know that that’s where we’re headed. And every avalanche of big rocks is preceded by the falling of little rocks. So one of the things that I think we’re going to start seeing is we’re going to see a lot of pressure on stock prices and bond prices and on bond defaults, particularly by at risk financial companies and companies that are not currently able to pay down their debt for zombie companies. So the proverbial question is, what should you do about this? Now, of course, I’m not a registered investment advisor, and so I’m not necessarily the person that you would go to right away for financial advice. I mean, I’m more than happy to have a conversation about these types of things with anybody who wants to discuss them. Of course, I make my own financial decisions for my portfolio, but I’m not currently in the business of managing other people’s money. But I would definitely recommend having a conversation with the person who manages your money or possibly considering looking at managing your own money. Because one thing to remember is that a lot of the people who are in the money management business, their views are shaped by their views are shaped by their experience for the last 10, 20 years and not last 10, 20 years, other than the financial crisis, has been just a straight up market. One of the things that’s really important to keep in mind when it comes to financial markets is that anytime you have a bowl or bear market that lasts more than about three to five years everybody who is not with the current trend is out. So in other words right now the Bull market has been going long enough that every bear money market money manager, they’re out of business, they’re on the sidelines, they don’t have any capital.

So all the people who are making the most money are leveraged long money managers they are high risk, high growth they’re high risk, high growth expectation managers they will all be destroyed. The moment that what I’m talking about happens on the other side. When you have prolonged down markets what ends up happening is the Bulls are completely gone and the only people left in the market are the ones who are very pessimistic and because, of course all the people who are optimist wants to get creams enough times they get stuck on the sideline. So one of the things to bear in mind as you’re looking for financial advice potentially as this environment is getting really volatile is look for somebody who really understands the macro environment and how that is going to impact the financial markets because if you just look at how things have operated that is fine as long as you’re in the middle of a trend once you hit a turning point and those fundamentals change if you are investing using old paradigms you could get creamed. But anyway that is not like me giving financial advice, that is just me saying hey this is Doug talking to you and giving you my insights. So anyway I really appreciate listening for today and I’m looking forward to talking to you next week.

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