One of the great ironies of QE is that while the post-crisis monetary policy regime was designed and implemented to reflate the global economy, there are certain places where these policies are actually deflationary.
And when you think about it, it’s common sense. If you artificially suppress borrowing costs and distort the supply/demand dynamics in the fixed income market in order to engineer a hunt for yield, what you invariably end up doing is creating a “zombie” dynamic whereby otherwise insolvent companies are kept in something akin to suspended animation by virtue of wide-open capital markets.
This is part and parcel of the whole “up the down escalator” dynamic in the oil market. Uneconomic U.S. production was allowed to effectively hibernate during the price downturn thanks in part to the fact that capital markets never completely slammed shut and then, when prices began to rise again, producers found markets even more willing to keep the spigots open thus encouraging still more production.
This is the dynamic that led Anadarko boss Al Walker to liken his own industry to a gang of hopeless alcoholics last year.
“The biggest problem our industry faces today is you guys,” Walker told investors at a conference last June. “It’s kind of like going to AA. You know, we need a partner. We really need the investment community to show discipline.”
Of course you can’t expect the investment community to “show discipline” in an environment where yield is an endangered species. The relentless chase down the quality ladder catalyzed by central banks dumping $15 trillion-ish at the top of that same ladder ensures that everything gets priced to perfection on the way down, with the sole exception of companies that are on the verge of default. Recall this schematic from Citi:
This raises questions about what happens when the accommodation that creates that dynamic fades or, more to the point, when central banks start to wind down their balance sheets. What happens to the zombies (so to speak)?
This is a pressing issue in Europe as the ECB tapers APP. So far, Draghi has demonstrated a propensity to lean on PSPP when it comes to shouldering the taper burden while keeping the CSPP bid largely in play. The Steinhoff debacle raises still more questions – that is, what happens if the ECB actually becomes an active seller of fallen angels while it simultaneously stops actively buying IG? Does that then set the stage for some kind of acute domino effect that causes spreads to blow out? More on that here and here.
Well in a new note, BofAML revisits the zombie problem (see here for some highlights from their original exposition) and the following chart is extremely telling:
So obviously that’s the 6-month change in the Fed’s balance sheet against HY energy defaults and as BofAML notes, “as the rate of growth in the Fed’s balance sheet slowed to zero in March 2015, US high-yield energy defaults began to rise.” Here’s more:
The growth of US high yield energy debt had been tremendous between 2012 and 2014 – with the market almost doubling in size – as the shale phenomenon took off. Overlending in the sector thus became problematic. And while other risk-off factors materialized in 2015 to pressure US energy defaults – such as China weakness and a falling oil price – we find it nonetheless revealing that when the Fed stopped QE, leveraged capital structures in the US credit market began to suffer. “Misallocation of capital” had come home to roost…
Yes indeed. And now the question is whether the chickens are on their way home in Europe. Here’s BofAML again (note that “zombie” just refers to companies with an interest coverage ratio below 1X):
And so what of the fate of “zombies” in Europe? In Chart 13 we plot the number of European zombie companies, over time, together with the rate of change of the ECB’s balance sheet. An interesting relationship unfolds, in our view, with similar conclusions to the US example above. We find a reasonable link between the rate of growth of the ECB’s balance sheet over time and the growth rate of European zombies. When the ECB has been supporting markets through periods of QE, zombies have been growing in Europe, as companies have used the cheap liquidity to “live for another day”. But when the ECB has been shrinking its balance sheet (LTRO roll-offs etc.) the number of zombie companies has declined – and the default rate has consequently risen.
There you go. You can draw your own conclusions there, but the implication is that as QE rolls off across the globe, you can expect defaults to rise.
So this is probably the only context in which “less zombies” is actually a bad thing – unless of course you get a kick out of watching creative destruction play out before your very eyes.