Monthly Agenda June 2020 – The Walking Fed
Twenty years ago, “The Simpsons” famously aired an episode of Donald Trump as President of the United States. Ten years ago, the television series “The Walking Dead” introduced us to a virus that creates a zombie apocalypse on earth. Today, (the real) President Donald Trump oversees a virus-hit economy increasingly occupied by zombie companies. It’s strange how prescient fictional television programs can be.
What is a zombie company?
A zombie company is a company whose profits are less than its debt servicing costs. The term rose to prominence in 2018 when the Bank of International Settlements (BIS) researched the rising incidence of these kinds of companies. The BIS studied the factors behind the rising prevalence of firms that could not meet their debt servicing costs from current profits. It found the increase was linked to reduced financial pressure, which in turn was linked to lower interest rates in the economy.
Chart 1. The share of zombie companies listed in the US (%)Enlarge Source: Deutsche Bank
Chart 1 shows how after a small decline in the late 1990s the number of zombie companies in the US increased in the early 2000s and then increased exponentially in the wake of the global financial crisis in 2008. A similar situation occurred in Australia (Chart 2).
Chart 2. The share of zombie companies listed on the ASX (%)Enlarge Source: Coolabah Capital Investments
True to their fictional form, zombie companies are a problem for society and for the economy. They are less productive than other firms; they crowd out investment; and they reduce employment at healthier companies.
How do they survive?
The rise and fall of zombie companies can be explained by the interest rate cycle. When interest rates are decreasing, highly levered companies have more room to survive and so grow and increase in number. When interest rates are rising, financial conditions tighten forcing companies to restructure or declare bankruptcy, therefore decreasing the number of zombie firms.
A healthy economy is one where companies are allowed to fail. Historically, one new business is born every minute in the US, while another one fails every eighty seconds. In Australia, a new business is created every ninety seconds while one fails every one hundred seconds.
As can be seen in Chart 3 however, since peaking in 2009, the level of bankruptcies in the US has been steadily declining. There are around a third fewer bankruptcies today than the long run average.
Chart 3. The number of US business bankruptciesEnlarge Source: United States Courts
These members of the walking dead remain animated because they are being sustained by the US Federal Reserve (the Fed). Cheap credit is abundantly available allowing them to term-out their debt well into the future. A frighteningly high percentage of the record bond issuance in the US currently is targeted for refinancing purposes. A healthy economy would see such credit creation going toward new, productivity-enhancing, investment.
Never mind that profits are wafer thin and that their business operations aren’t viable right now. As long as they are propped up by the Fed, investors are willing to lend to the zombies.
Why is the Fed supporting the Walking Dead?
The US economy, like Australia, has just passed through one of the longest periods of uninterrupted economic growth on record. The expansion that began in 2009 was the longest on record for the US economy (until it ended in February this year). In fact, the twenty-tens was the first (and only) decade to have passed where the US didn’t experience a recession (Chart 4).
This is good because it reduces the amplitude of the economic cycle and the level of uncertainty with it. It is bad because the side-effect is greater risk taking. US corporate debt levels have risen to the highest level ever as a share of GDP (Chart 5).
Chart 4. The number of months the US has been in recession (by decade)Enlarge Source: Deutsche Bank
As the late American economist Hyman Minsky wrote in his book “Stabilizing an Unstable Economy”, long periods of uninterrupted economic growth leads to complacency, and complacency leads to excessive risk taking which ultimately leads to vulnerability.
This has been proven to be true time and time again. The period from the mid-1980s to 2007 was known as The Great Moderation. The business cycle was thought to be dead. Economic growth was high and volatility was low. As we now know, complacency set in, imbalances built up and the onset of the global financial crisis in 2008 proved that the business cycle was very much alive.
Chart 5. US corporate debt levels (% of GDP)Enlarge Source: Bloomberg
Today, what the Fed, and indeed some twenty-five other central banks around the world, are trying to do is to stabilise the (now) unstable economy. Corporate debt levels have built up to such an extent over the past dozen years that the economy has become vulnerable. The illiquidity issues caused by the COVID-19 crisis risks transforming this debt load into a serious insolvency crisis.
The Fed is using every tool in its armoury to try and avoid this. Unfortunately, the tools available are far from precision instruments. In the process of supporting genuinely healthy companies, the Fed is also supporting the unhealthy. Fiscal policy is a far more precise instrument but has been missing in action until recently.
An economy that is filled with the walking dead is one that is less dynamic, less productive, and less efficient. A healthy economy is one where the weaker companies are allowed to die, creating room for the living to thrive. This is known as “creative destruction”.
Business dynamism is inherently disruptive; but it is also critical to long-run economic growth. Research has shown that this process of creative destruction is essential to growth in the economy. More productive firms drive out less productive ones, new entrants disrupt incumbents, workers become better skilled and living standards rise. In other words, a dynamic economy constantly forces labour and capital to be reallocated and put to better uses.
Since 2008, the Fed has progressively interfered in this process. The original intention of the asset purchase program was to lift asset prices, raise the level of household wealth and so boost consumption. The problem with that thesis is that not everyone owns the assets whose prices are rising. And so instead of seeing a boost in wealth leading to a rise in consumption, we saw a rise in wealth for the higher income groups only.
This time around the intention of the Fed to is to intervene in the market in order to “extend the cycle”. The level of corporate indebtedness is now so high that the process of creative destruction could potentially be too destructive for the economy to bear. Extending the cycle is seen as the next best option – encourage the economy to grow and inflate its way out of the debt issue.
How do you survive a zombie apocalypse?
Investors need to be equipped with the right tools in this environment:
1. Know your zombies. This is where active management is required. Passively investing into an index assumes the benchmark against which the index is managed is a risk-free starting position. It is not. There are many risks embedded in a passive benchmark that are not worth taking. Active management allows investors to strip out the risks not worth taking and only take those that are.
2. Explore corners of the market where the walking Fed doesn’t tread. Private markets are becoming more interesting in this regard given they are outside the scope of the Fed’s asset purchase program.
3. Elevate risk management in your thinking. Investing in private or unlisted corners of the market introduces illiquidity risk which must be balanced within the overall portfolio. Having a genuine “liquidity bucket”, a portion of the portfolio made up of securities that have been liquidity tested under extreme conditions, will help to balance the overall portfolio.
4. Focus on growth over value. The growing number of zombie companies will weigh on economic growth by suppressing productivity. The implication is that interest rates and inflation will similarly remain low. In this environment, growth-oriented investors will do better than value.
5. Dial down the tactical tilts. A market haunted by zombie companies draws in short-term speculators looking to benefit from the momentum they create. This momentum can turn quickly making it a very difficult market to time. Only make tactical decisions when there is a clear and large disconnect. Otherwise, stay close to your strategic benchmark.
 U.S. Census Bureau, Business Dynamics Statistics
 Australian Bureau of statistics, Counts of Australian Businesses, Cat No. 8165.0
 Minsky, H., 2008. Stabilizing An Unstable Economy. [New York]: McGraw-Hill.
Chief Investment Officer