Fieldpoints of View: Leverage
First, a Story
In May of 1889, heavy rains poured down over western Pennsylvania. In the mountains above a small town called Johnstown, there was a 30-year old dam that had been initially built to supply the Pennsylvania canal network during the dry summer months. The six to twelve inches of rain experienced that May might not have been a problem for a dam of that size, but the South Fork Dam had been the victim of short-term thinking in recent years. The dam’s original system of relief valves and pipes had been sold for scrap, while maintenance had been deferred to save expenses. Then, in order to turn the reservoir into a lakeside resort, the top of the dam was lowered to make way for a wider road and nets were installed to keep fish in the lake. These changes all served to reduce the capacity of the dam’s spillway, or how much water the dam could controllably release downstream. So when those heavy rains came in 1889, there was nowhere for the water to go except up over top of the dam, called overtopping, eventually causing the dam to collapse. This released 20 million tons of water traveling at 37/mph on Johnstown below, the equivalent force of 70% of a kiloton of TNT. Over 2,200 of the towns 30,000 inhabitants were killed, making it the second worst manmade disaster in U.S. history, only behind the 9/11 terrorist attacks.
That’s the thing with dams. In order to remain long-term strong and resilient to shocks, like heavy rainfall, they have to be able to let off enough pressure, or water, in the near-term. If you try to limit the amount of water that the spillway releases downstream, you run the risk of not being able to weather unforeseen conditions in the future. In a way, the release of pressure in the near-term keeps the dam functioning and safe in the long-term.
There is a similarity here to capitalist market economies. The release of pressures in the near-term, such as company bankruptcies/restructurings and market corrections, actually serve to reinforce the long-term strength of the economy by making sure that capital is allocated to its most efficient use. These near-term volatilities “do maintenance” on the economy by keeping companies and investors from growing complacent and increasingly fragile to shocks.1
In 2020 we deferred this maintenance and we accomplished this through an unprecedented increase in leverage. By the end of 2020: global debt to GDP reached 355%, developed country borrowing increased 60%, U.S. debt to GDP reached 130%, U.S. high yield corporate debt borrowing grew 60% and trader leverage grew at a pace of 70% over the prior ten months.
Leverage fueled backstops, bailouts and liquidity injections that smoothed out the volatility and stresses in the near term. Despite the degree of the economic shock, bankruptcies were avoided (Chapter 11 filings only grew by 8% in 2020 compared to 38% in 2007 and a further 77% in 2008), consumer incomes increased (unheard of in a recession), and markets experienced unprecedented V-Shaped rebounds.
Bold actions in the midst of the health crisis were laudable in order to allay the human and economic damage of infection-curve-flattening lockdowns. However, as forward-looking investors we must assess the implications that this aggressive use of leverage will have on future growth, returns, policy and volatility.
We must be abundantly clear at the start to note that in writing about leverage we are not intending to warn against an imminent repeat of the Great Financial Crisis (GFC). Many of the areas of leveraged excess that drove the near implosion of the global financial system in the late 2000’s are far healthier today than they have been in decades. This indicates that these areas, such as bank and consumer balance sheets, are unlikely to be the source of the next debt cycle/crisis.
However, just because we are not arguing for a repeat of a once-in-three-generations financial crisis does not mean that we should tacitly ignore the incredible rise in leverage. Just as we have identified that bubble conditions do not tell us much about when a cycle will be over2, but instead help us predict how the end of the cycle will play out3, there is a similar and related conclusion with leverage.
There is an appendix at the end of this paper that provides a deeper dive on many of the topics and data discussed.
The Real Costs of Leverage
The biggest pushback to a discussion about high leverage levels today is that interest rates remain historically very low, making the cost to service debt much more manageable than in prior periods. The cheap current cost is true: 80% of the OECD debt raised in 2020 carried an interest rate of less than 1%. But this rock bottom debt servicing cost is not permanent and ignores the much broader costs of high leverage.
First, most debt must be refinanced4. Raising debt to record levels at record low prices means that the cost of servicing this debt will rise unless interest rates remain at record lows. This entails that the highly leveraged economy will be increasingly sensitive to any change in the cost of this debt, or interest rates. Thus, central bankers could be backed into a corner, where interest rates must be kept low at all costs so as to not cause a shock to a financial system built on cheap debt.
Second, debt further reduces future flexibility. Even if the economic school of “deficits don’t matter” proves to be correct, and if investors are willing to lend at increasingly high debt-to-income levels, there is an observed diminishing marginal utility of debt. This means that adding more debt to fuel spending has less and less impact on growth, eventually reaching a level where incremental debt detracts from growth.
Third, as mentioned earlier, leverage used to smooth out volatility can sow the seeds of greater volatility in the future by breeding complacency. Weak companies stay in business because they have access to relatively cheap capital5, so companies become complacent because there is less perceived existential risk. Dynamism fades, creative destruction is halted. Seen another way, investors become conditioned to expect V-shaped recoveries after every market shock, due to a seeming unwillingness for policy makers to tolerate market volatility. This leads to higher risks exposures and overconfidence.6 As Hyman Minsky outlined, low volatility induces market participants to take on more risk, effectively increasing the likelihood of future shocks.
Fourth, and related, leverage is a double-edged sword. It amplifies the upside experience in strong markets, but it also amplifies the downside experience in down markets. More than just the point of delaying volatility breeds greater future volatility, leverage creates positive and negative feedback loops (or buying begetting more buying, selling begetting more selling). Rapidly growing margin account balances and options trading is fueling current market upside today. However, the cost of this leveraged upside today is a more rapid unwind in the future.
A Blurb on Carry
At the intersection of the near-term dampening of volatility and the amplifying of upside and downside is carry. Carry trades are those where investors borrow money at low cost and use the proceeds to invest in a higher return security or asset. Many are familiar with currency carry trades (borrowing in a low interest rate currency to invest in a high interest rate currency), but the carry regime has expanded into many other asset classes, including equities.
Carry trades increase leverage in the market. They also feed on low near-term volatility and cheap funding costs, both of which have been enabled by the policies described above. The problem with carry trades, like other forms of leverage, is that when these levered positions unwind, they can create sharp spikes of volatility in assets. The result of having a market where carry trades proliferate is periods of perceived low volatility followed by brutal and fast spikes in volatility that often require even more policy intervention. This is an important, yet complicated concept that is well articulated in Lee, Coldiron and Lee’s The Rise of Carry.
Why Should We Care About Leverage Today?
Similar to knowing you are in a bubble, knowing that leverage is high does not foretell an imminent unwind. However, high leverage does tell us that when an unwind eventually happens it is likely to be swift and of meaningful magnitude. Leverage is seen in the crescendo of recent booms and busts, where each successive crash is larger and requires an increasingly behemoth policy response.
Knowing that leverage is high also allows us to be more resilient to narratives that can be dangerous in the giddiest days of a market cycle. The investor that is aware of leverage knows that leverage amplifies the upside and the downside, meaning frothy valuations are propelled and sustained by ever increasing leverage (until they are not). This awareness breaks the spell of “this time is different” and “new paradigm” narratives that emerge to justify heady valuations.
Lastly, knowing that leverage is high gives us direction on where to allocate capital. As we are seeing in the recent intense market rotations, investors must be aware of where there are the greatest sensitivities to increases in the cost of money. Long duration growth stocks do not respond well to increases in the cost of money. Low quality/high leverage companies can struggle to continue to access funding if markets determine that liquidity can’t solve solvency or structural problems. Debt that is inexpensive thanks to attempts to suppress near term costs and volatility has the potential to reprice rapidly (prices fall, yields rise), as the central bank “peg” starts to erode. This does not mean investors can’t have exposure to these areas, but the risk exposure must be controlled. To gratuitously continue the dam metaphor, be a visitor to the river, only fishing downstream of the dam, instead of building your dream home right on the sandy riverbank.
These long-term assessments of leverage support our positioning conclusions from our 2021 Outlook: expect market rotations (Value, international, etc.) to be the driver of returns in 2021 with limited upside at the large cap index level. Be wary of bubble-like conditions in the market, mainly the winners of the bizarre economic and trading environment of 2020. Focus on dividends as a key source of returns and possibly use dividends to keep from having to chase yields in expensive/riskier fixed income markets. Further, do not chase yield through uncompensated credit and duration risk, as slim yields get quickly consumed by price losses if rates rise or credit events occur. Commodities have a place in the portfolio as an inflation hedge. Alternative investments become increasingly important diversifiers and return enhancers given historically high valuations in conventional asset classes.
Appendix: Leverage by the Numbers Total Debt
Total global debt from governments, companies, and individuals increased by $24 trillion to $281 trillion at the end of 2020, according to the International Institute of Finance (see Chart 1). This equates to more than 355% of global GDP. There is little expectation that this debt load can stop its expansion in 2021, given countries’ commitments to continue to provide pandemic related support.
The biggest pushback to worries about leverage levels is that this new debt is exceedingly cheap. OECD countries, or the 37 “rich countries”, increased debt issuance by $18 trillion in 2020, equal to 29% of GDP (up from 17% of GDP in 2019). Despite this 60% increase in year-over-year issuance, funding costs plummeted. 80% of the debt was issued with an interest rate of less than 1%, including 20% of the debt being issued at negative rates. Funding costs were kept low thanks to central bank intervention, with the OECD estimating that central banks purchased $4.5 trillion of government debt in 2020. Of course, this ballooning of debt also puts pressure on central banks to keep interest rates low going forward so as to not cause a spike in funding costs for governments as they refinance and continue to issue more debt. This is another display as to how each successive crisis requires a greater level of intervention, where we are now at a point where the intervention has to remain well after the crisis is over. The proverbial punch bowl cannot be taken away without significant disruption.
U.S. Government Debt
Public debt in the U.S. surged in 2020 in order to fund the 43% increase in government expenditures over the course of the year. The U.S. has crossed the much-watched threshold of debt to GDP at over 100%, with total debt held by the public exceeding $21 trillion at the end of 2020. When including intragovernmental debt, like Social Security, the debt balance grows to $27 trillion, with a debt to GDP ratio of 130%. Looking ahead, the Congressional Budget Office expects a $2.3 trillion budget deficit for 2021, even before accounting for the $1.9 trillion of additional COVID stimulus (not to mention a potential infrastructure bill). At 10.3% of GDP, this preliminary deficit, again before the inclusion of any additional stimulus7, would be the second highest deficit as a percentage of GDP since 1945 (2020 was the highest at 14.9% of GDP).
The U.S. also benefitted from record low interest rates. Interest expense for the U.S. government fell -4% in 2020, despite the 43% increase in expenditures. As a percentage of expenditures, interest costs fell to 8% of expenditures, down from 12% in 2019 (see Chart 2). However with an average maturity of 5.5 years, the U.S. budget will be acutely sensitive to increases in interest rates, which would cause interest expense to start taking up a greater portion of the budget (potentially necessitating even more debt to avoid cutting spending in other areas).
As we discussed in “The Hidden Costs of Leverage,” the marginal productivity of leverage has been falling over the last 50 years. Chart 3 shows the dollar increase in GDP for each additional dollar of debt in the U.S.. In the 1960s, a $1 increase in debt in the 1960s coincided with an $0.80 increase in GDP. Today the increase in GDP for each additional dollar of debt is closer to $0.10-0.20 (when smoothing out the impact of the collapse in GDP and surge in debt in 2020, which resulted in a negative reading for the year).
Looking at corporate leverage, debt issuance reached records in 2020. According to S&P Global Ratings, global investment grade issuance increased 29% YoY in 2020, adding $2.6 trillion to reach $17 trillion of total investment grade debt. Despite the economic disruptions and a record number of downgrades, high yield issuance jumped an incredible 50% in 2020, bringing the total amount of high yield debt outstanding to $5.2 trillion. Looking at the U.S. specifically, in 2020 corporate debt as a percentage of GDP reached a record high of 83.5% (up from 75.7% at the end of 2019). There was a particular surge in low-grade issuance (+60% in 2020), with speculative grade debt now 58% of the total U.S. corporate debt outstanding. There were record downgrades in 2020 (910 vs. 483 in 2019 and 789 in 2009), but S&P Global Ratings noted that in the second half of 2020, “the pace of downgrades slowed sharply on the back of trillions of dollars of government and monetary support for the economy.” Despite the downgrades, bankruptcies were minimal. In the U.S., bankruptcies increased only 8% in 2020, compared to 38% in 2007 and a further 77% in 2008 (see Chart 4). Again, less water, or volatility, being let out from behind the dam.
In the U.S. corporate debt to GDP now stands at nearly 350% (see Chart 5).
Further, despite companies having more debt, less earnings, weaker debt covenants and more defaults (junk default rate ended 2020 at 9% vs. 3.5% pre-pandemic), the return that investors are receiving for lending to these companies has fallen to record lows. Both absolute yields and corporate spreads, the extra compensation that investors receive over Treasuries for lending to riskier entities, spiked in the early days of the pandemic and then fell back to pre-pandemic and even record lows following the Fed’s direct intervention into these markets, along with its very easy monetary policy. The very easy monetary policy makes the return on safe assets lower and pushes investors into riskier asset classes as they reach for yield and return. Even the junkiest of the junk debt, CCC-rate debt, is now trading at record low spreads. Companies capitalized on this abundant and cheap liquidity through the record debt issuance, with many risky, possibly structurally impaired borrowers seeing insatiable appetite for their debt offerings. This hunger for yield by investors is allowing many borrowers to increase the size of their debt offerings and even lower the yield offered to investors.
Investors are getting less return for a higher amount of risk. Many companies that tapped debt markets are still holding elevated cash balances, but most analysts expect this cash to be spent (on M&A, dividends, or share buybacks) rather than being used to pay down debt (with the argument that the debt is so cheap).
The common push back to this discussion about corporate debt levels is that many companies have used the record low interest rates to “term out” debt, extending maturities in order to lock in low rates. Many issuers have capitalized on this opportunity, however, of the $17.5 trillion of total U.S. corporate, there is still $5.3 trillion of this debt that is scheduled to mature by 2025. This means that if interest rates don’t stay near record lows, corporations will be faced with increasing interest expense as they refinance. Further, $3 trillion of that $5.3 trillion of debt maturing is rated BBB, the cusp of investment grade and junk status. This means that issuers could face further increases in interest expense if their debt is downgraded.
The last piece of debt increases comes from the consumer. We are not overly concerned with household debt at this time (though it did reach a record $14.6 trillion in 2020 on the back of a 5% annual increase in home loans, but credit card debt actually fell 12% in 2020 thanks to the direct stimulus checks from the U.S. government). Where we are focused is leverage related to public asset markets. Thanks to the V-shaped recovery in the equity markets and the rise of the retail investor (we go into the factors that caused this in great detail in both our 2021 Outlook and Episode 1 of our podcast Fieldpoints of View), we have seen a surge in margin loan balances as novice traders have been increasingly emboldened and risk-hungry, looking to amplify their trading returns through the use of leverage. According to FINRA data, margin loan balances have surged nearly 70% in the last ten months to a record $799 billion. Surges in margin loan balances have typically been observed in the late and headiest days of bull and bubble markets (such as 2000 and 2007). Thanks to the soaring stock markets, the margin loan balance as a percentage of market cap is not at prior market peaks, however seen another way, margin loans as a percentage of GDP is above both the 2007 and 2000 peak (see Chart 6).
Another way to see trader leverage is the surge in option volume. Options are a form of leverage and are a (risky) way for traders to amplify returns by many multiples. The option volume has been dominated by the purchase of bullish call options as traders look to maximize their upside on their optimistic bets. Call option volume has risen to records (see Chart 7), while the put/call ratio (how much investors are willing to pay for downside put protection compared to upside call potential) has fallen to near-record lows, indicating elevated bullishness, complacency, and one-sided positioning in markets (see Chart 8).
1 For a detailed look at the concepts of fragility and anti-fragility read Nassim Taleb’s Anti-Fragile.
2 Many analysts and investors conflate being in a bubble with being near a market top. These are not the same thing, as bubbles have a tendency to persist and intensify for, what can be, an extended period of time. In the late 1990’s we had bubble like conditions for well over three years before the eventual unwind. Those identifying that we were in a bubble in 1998 were not wrong, however if they also used this bubble characterization to call for the imminent peak and decline in the market, they would have been far too early.
3 More rapidly and with greater downside as excessive valuations, positioning and leverage have to be unwound.
4 Didn’t borrows term out debt in 2020? Some did, but the average maturity of U.S. Treasury debt is still 5.5 years, while 30% of U.S. corporate debt will mature before 2025.
5 Accomplished by the Fed lowering interest rates, flooding markets with liquidity, expressing a willingness to be a buyer of corporate debt and pushing investors out on the risk curve so they are forced/eager to take on higher and higher risk to reach for ever declining yields/returns.
6 Nassim Taleb makes the important point in his book Anti-Fragile that the cumulative impact of the small near term volatilities is far less that the impact of the deferred large volatility. Just like the dam, we create greater risk in the future by trying to avoid risk today.
7 Some of this additional stimulus is expected to be funded out of the Treasury’s elevated cash balance.
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