Domestic Debt & Global Discrepancies

Standard & Poor’s released its current ‘U.S. Distressed Debt Monitor’ yesterday, noting that the distress ratio of U.S. corporate issuers has fallen to another all-time low, continuing a three-and-a-half year long trend (to access the full S&P report, start here). This datapoint does not fit well with bearish outlooks on financial conditions and the economy. Some thoughts:

• While certain sectors of markets and the economy are facing challenging conditions, these situations have to be looked at in context. For example, the current recession in the homebuilding industries is occurring in the wake of a long boom period. Home values have finally returned to a rough parity with incomes, and positive effects from more favorable tax treatment of home sales (1997) may have run their course by now; both factors would tend to flatten the trajectory of home price increases. Differences in domestic and global conditions also play a role, as noted below.
• U.S. consumers are leveraged, but labor markets remain tight, and corporate cash flows and balance sheets are healthy. As long as the U.S. continues to enjoy a reasonable proportion of global economic activity and investment, a slow and steady expansion should continue.
• According to the report, the positive impact of a low distress ratio is offset by the  negative effects of an inverted yield curve. This brings us back to the ongoing bond market "conundrum", the current episode of which has yet to play itself out. If the Treasury market is right, then corporate distress levels will eventually increase, thus justifying the some pessimism about the economy. On the other hand, if long term interest rates correct to a higher level, then the outlook for corporate debt performance–and the economy–should improve even further. And as fellow finance nerds will acknowledge, the lower duration of higher coupon speculative credits should help keep a lid on the distress ratio.
• The most important takeaway from the report, which is supported by the bullish state of industrial commodities and similar markets, is that financial liquidity remains plentiful overall. That comports well with what the Bernanke Fed has been saying, and contradicts what the bond market’s inverted yield curve is telling us. When liquidity is plentiful, higher output and inflation are the more prevalent risks, and for that reason, we continue to bet on the Fed’s hawkishness and against Treasury market dovishness.
• Theoretically speaking, the Treasury market will be proven correct only if (when?) the Federal Reserve sets a target rate that (plus inflation) is higher than the "natural" rate of return in the economy. There are two important things to consider here. First, we must keep in mind that global economies are increasingly integrated, and that the U.S. dollar is still the primary currency of choice for global transactions and reserves; thus, to a great extent, it is the natural rate of return in the global economy that determines whether the Fed’s target rate is likely to be expansionary or restrictive. Second, given the high returns on capital currently available in the global economy, the Fed is likely to surpass "neutral" only after another 50-100 basis points of rate hikes. That is the difficult reality that faces certain sectors of the U.S. economy (subprime lenders and borrowers, for example), where the cost of capital now exceeds expected returns on capital. As we’ve noted before, leveraged sectors of the U.S. economy face a situation similar to that faced by emerging markets in the mid to late 1990s, and that portends a domestically painful combination of either a higher fed funds with additional economic dislocation in certain sectors of the economy, or a higher rate of inflation and its attendant problems.

That last observation is getting some public attention, albeit in a piecemeal way, as commentators and politicians fret about things like consumer leverage, and advocate measures like tighter regulations and/or household budgeting. Looking at the situation in total, it’s our view that the best solutions are those that would remove constraints to economic activity, and thus raise the "natural" rate of return here at home; there are politically palatable measures that can be undertaken to lower barriers to investment and entrepreneurship, but it’s unclear how effective these would be in the long run–especially when compared to a measure that, while far more more controversial politically, would offer the biggest bang for the buck–lower corporate income taxes! In fact, the most powerful approach would be to drop taxes altogether on productive activities (income and investment) and replace them with a simple, efficient, consumption based system. We can think of nothing that would do so much to: (1) level out domestic/global discrepancies roiling certain parts of our economy and (2) allow us to avoid the nostrums of ‘root canal’ economics.

Of course this same ‘Wicksellian‘ framework illustrates how a downturn might come about: if the Fed remains hawkish in coming years in order to contain inflation expectations (i.e., a level or higher real rate) and politicians enact measures that lower the natural rate of return (e.g., by allowing tax rates on capital to increase via expiration of the 2003 tax cuts) then contraction and deflation could very well follow.