The Fed's $29 Trillion Bubble

So last Wednesday, I wrote that the ongoing stock market sell-off was the Fed’s fault.

“…each of the bear market buzzwords share a common theme: investment. China, oil companies, emerging markets — they’ve each invested money based on assumptions that are proving to be, if not outright false, at least misguided.

And we’ve really only got one source for the misguided notion that growth and demand would be enough to justify massive investment: the Fed.

…the Fed was adamant that it could foster real economic growth by making money cheaper and encouraging borrowing and investment. So it left interest rates at zero and tried to pump liquidity into the system via quantitative easing.”

It’s all well and good to talk about the Fed and the economy in these terms. But they are also a bit abstract. So I thought today I’d add a little color and some dollar signs to the equation to show more clearly how the Fed got us where we are today.

As a starting point, let’s reiterate that for a real economic recovery, there needs to be investment in new production. But there also needs to be demand. And as we know, demand is not as strong as it needs to be. 

The American oil sector serves as a great example of how this works. Between 2010 and 2014, U.S. oil companies took on $500 billion in debt to fund their drilling programs. U.S. oil production jumped from 7 million barrels a day to 10 million barrels in that time. When oil was $90 a barrel, this made total sense. 

Sure, the supply of oil rose dramatically. And demand for oil tends to rise due to demographics. So U.S. oil companies’ investments in new supply would make sense, if it weren’t for one little detail: The Saudis boosted their production, too.

I suppose there’s no reason to expect the Saudis to want to drive prices lower by overwhelming demand with new supply. But at the same time, using prices to do battle is not unheard of. That’s the strategy Wal-Mart used to become a behemoth. It attacked other retailers with lower prices, pushing local businesses out of the game because they simply couldn’t compete on price. 

Pricing power for a business is often a potential vulnerability. U.S. oil companies, along with Russia and pretty much every other oil-producing country, were vulnerable to price, and Saudi Arabia is putting the squeeze on everyone.

What Cheap Oil Means

Now, when prices fall, economic theory says that demand should increase. That’s exactly what’s happening with oil.

At $90 a barrel, demand was growing at about 1.2 million barrels a day. But even now, demand is growing at around 1.5 million barrels a day. And if oil stays at $20 a barrel, demand will rise to 1.7 million barrels a day. 

Americans are driving more miles, and the Chinese are buying more SUVs (SUV sales are up 60% year over year, according to some Bank of America research).

Gasoline is cheaper, and the consumer is benefiting. In fact, the same Bank of America research suggests that the fall in oil prices could put $3 trillion in global consumers’ pockets over the next four years.

But of course, we are talking about the stock market here, not the consumer. That $3 trillion windfall to consumers doesn’t come out of thin air. It will come out of global oil companies, many of which have stocks on American exchanges.

And it goes deeper than that. Banks have lent money, investors have bought bonds, and countries depend on oil revenue for their budgets. 

So the consumer might be stronger due to low oil prices, but many other entities are weaker. 

Now, that’s just oil we’re talking about. And it’s a $3 trillion issue. The reality is that a somewhat similar dynamic is playing out in the global economy, and the stakes are closer to $29 trillion…

The $29 Trillion Problem

With oil, we can see that when you make something cheaper, consumers tend to use more of it. The same is true with money. The Fed and other central bankers around the world made money really cheap by dropping interest rates to zero and pushing yields down with quantitative easing. The result is that companies have borrowed a lot of money…

Click Chart to Enlarge

This nifty chart from S&P Capital tells the story. Globally, companies have taken on $29 trillion in debt over the last few years. The ratio of debt to earnings is at a 15-year high. Now, companies have to pay more to service their debt, and those payments come out of earnings. 

And earnings are barely growing because the total demand is barely growing. And that raises the possibility that more companies might be vulnerable, just like how oil companies are/were vulnerable.

In 2015, S&P gave downgrades to 863 companies because of rising debt levels. Fitch Ratings says that 6% of all U.S. corporate bonds were downgraded in 2015, the most since 2009. 

This exposes the fundamental flaw in the Fed’s interest rate policy. Yes, they were correct in assuming that cheaper money would lead to more borrowing. They were not quite right in assuming that more borrowing would lead to more spending. But they’ve totally whiffed on the assumption that more spending would lead to higher prices…

You’ve probably heard the Fed say that inflation remains below target levels or something like that. It’s a problem in the same way that low oil prices are a problem for oil companies.

As consumers, we don’t want to cheer for higher prices. But if prices don’t rise, how will corporate borrowers pay off their rising debt loads? And if companies have a problem paying their debt, what happens to earnings and stock prices?

On a fundamental level, this is why the stock market is getting whacked. And with global GDP already weak, it’s why the threat of recession has increased. Companies are more likely to spend less now than they have been in a few years. 

Now, this doesn’t mean that recession is a guarantee and that stock prices are going a lot lower. Stock prices have already sold off to account for slowing growth and lower earnings. The key now is to pay attention to signs that the situation will change. Watch inflation numbers. Indications that inflation is picking up will be good for stocks. Pay attention to Fed rhetoric, too. If they continue to suggest they want to raise rates and make money more expensive, stock prices will go lower. 

And finally, watch oil prices. It’s not the only commodity in the world, but it’s the most important. The day the Saudis cut their production will mark a big rally for stock prices.

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.