Markets Insight

Discovering the destructive force of excess capital

Corporate unease to intensify as easy money era fades
For examples of the strange spot the financial world is in, let us examine the desks of investment banks which help companies raise money.

Look left and it is megadeals, giant mergers and acquisitions, which need tens of billions of dollars sunk as foundations for corporate empires.

Look right, however, and the clients are miners and energy companies desperate for capital to pour into holes in the ground, dug when demand for commodities seemed insatiable. It’s boom times or the of end times, depending on which desk takes the phone call.

Into this environment has stepped the Federal Reserve, raising US interest rates for the first time in almost a decade. It isn’t the start of tighter monetary policy — that was October 2014 when the central bank ended its programme of bond purchases. Rather it is the first conventional step after several years without.
Still, compared with pre-financial crisis history, or the policy rate across the Atlantic set by the Bank of England, short-term interest rates at up to half a per cent still look like a dramatic attempt to stimulate the economy.
Two worlds also appear when we consider the Fed’s dual mandate to address jobs and prices.

The US economy has been adding more than 200,000 jobs a month for three years, and the unemployment rate has fallen from more than 10 per cent to half that, a level seen only briefly in the past four decades, during the dotcom and housing booms.

Meanwhile, expectations for US inflation — implied by the, admittedly, more limited experience of bond markets — were only lower in the more nervous moments of 2009. Janet Yellen, Fed chair, said on Wednesday the pace of future rate rises would be “gradual”, but the so-called “dot-plot” of Fed committee member forecasts indicates four increases next year, a more urgent schedule than market prices imply.

A final conundrum then, and a thread which runs through it all: cheap capital. Prices for high-yield bonds have been falling for a year-and-a-half as investors have reassessed the income they are prepared to accept to lend to the riskiest borrowers. Distress is real, particularly for oil and gas companies faced with tumbling prices for their product, and it is an open question how long banks will support businesses which lose money on each barrel of crude sold for less than $40.
Higher borrowing costs typically signal trouble ahead. Some companies will struggle to pay, or will simply be unable to refinance existing debt, and so default. Yet widespread failures still seem unlikely anytime soon, because less than a tenth of US high-yield debt outstanding comes due in the next three years, so great was the refinancing when money was cheap.

It may be tempting to see trouble for energy groups as disconnected, but remember that while production was enabled by technology, the cost of land, infrastructure and drilling was paid for by Wall Street with sales of debt and equity. When hedge fund manager David Einhorn toted up the numbers in May, he estimated the large frackers alone had spent $80bn more than they had received from selling oil.

The excess of capital leads to its own destruction, a glut of oil and gas which has helped to crash prices. It seems optimistic, however, to think the disruptive effects of cheap money haven’t been building elsewhere. In media for instance, Liberty Global and French rival Altice have used debt to roll up collections of cable and telecoms companies at the same time online groups Netflix, Amazon and Google are throwing money at production of original TV content.
In pharmaceuticals cash has flooded biotechnology upstarts, while Valeant has been conducting an experiment in the use of financial engineering as an alternative to research and development. The turning of the credit cycle then is less about the immediate effects of higher borrowing costs, but discovering the limits and consequences of seven years of cheap capital.
Which returns us to the question of big takeovers and deals, and suggests the motivation may not be so far removed from the troubled raw materials producers after all. The desperation is different — a need to grow when profits and sales have stalled — and is perhaps less acute, but it adds up to a very strange kind of boom.

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