Stocks fell with losses accelerating in the afternoon as concerns over debt ceiling negotiations began to register with equity investors. The yield curve has become more inverted as short-term rates rise related to a likely rush in the government’s need to sell an elevated level of Treasuries after the crisis ends. Bonds haven’t been this appealing in years. As stock prices rise, and create higher P/E ratios while short-to-medium term bonds fall in price, the relative attractiveness of bonds increases and stocks look less appealing.
As for the debt crisis itself, the situation is pure theatre. The script, however, is unimaginative having been played out many times before. Republicans want spending cuts; Democrats don’t. Obviously, at some point, they will meet in the middle. When is the deadline to make an agreement. Treasury says as early at June 1. No one believes June 1 is a precise date. But most now feel that getting past June 15, when quarterly estimated tax payments are due, is less than a 50-50 chance without some short-term measure to raise the ceiling just a bit to buy more time. With that said, such a move simply delays the inevitable. This is a boring 2-hour play that no one, at least on the outside, wants to see extended to 3 hours. An extension, however, is better than a default. Congress has proven over and over that only a crisis can beget a solution. This White House has always had a tough time reaching a conclusion. Look at the exit from Afghanistan as a vivid example. At least both Biden and McCarthy are adamant that there won’t be a default.
But even without default, there will be complications. Treasury has been unable to sell a normal level of new debt since it has been required to start taking extraordinary measures to push the timeline for reaching the debt ceiling out as far as it could. One reason short-term Treasury yields are so high today lies in the realization that rates could go still higher once a crisis is averted. In addition, quantitative tightening, whereby the Fed reduces its balance sheet at an annual rate of $1 trillion, soaks up an equivalent amount of excess bank deposits. For some banks, the days of excess have passed. On the left side of the balance sheet are securities held and loans. On the right side are deposits and capital. If deposits decline, either securities have to be sold or fewer loans can be made. That depends for each bank on the relative attractiveness of security and loan yields. Loans yield more but carry more risk. In a time where recession looms, the answer is that banks require higher yields, both for securities they choose to own and loans they choose to make.
One measure banks use when making loans, perhaps the most important one, is the coverage ratio. Depending on the collateral needed, in the not too distant past, coverages needed to be greater than 2.5:1 meaning projected cash flow had to be 2.5 times annual interest payments. But with rates rising, and even assuming the cash flow expectations for the borrower remain the same, higher rates increase the denominator and lower the ratio. If annual debt service payments were $100,000 at a time when the Fed Funds rate was close to zero, and cash flow projections were $250,000, what happens when rising rates double debt service payments? The answer depends on the loan covenants. In easy money times, many loans were covenant light. You can see the problem now emerging.
It is particularly bad in the commercial real estate sector, especially for loans backed by office buildings. Home mortgages are typically made for a 30-year term at a fixed rate and are non-callable. The same doesn’t apply to loans for office buildings. While there may be a fixed yield component to the loans, it’s rare that rate is guaranteed for more than five years. Today, cash flows from most office buildings are down 10-20% or more. In some cases, they are down 40% or more. Almost all loans are non-recourse. The lender can’t go after the borrower in case of default. The borrower is only on the hook for its initial equity capital invested. Banks aren’t in the real estate business. They don’t want to repossess office buildings. Owners want to survive the crisis hoping for better days ahead. But if cash flow can’t cover costs before debt service, there’s a real problem. That’s what lies ahead. Vultures will step in and buy troubled buildings at a fraction of their prior values. Such a purchase will work because the buyer can afford to rent space at a fraction of market rates and still service debt. That sets off a decline in rates that will cause additional problems for existing landlords. This problem, at least so far, is largely centered on office buildings. Office buildings are in the eye of the storm for obvious reasons in a world where more people work from home. But it is still not of the order of the mortgage foreclosure problems of 2008. Losses are projected at $200-500 billion. Those will be largely confined to small and regional banks. Some will fail or have to be absorbed by others. It is quite possible that the days of deposit runs are ending with a handful of failures already in the books. But as an economic slowdown or recession comes to fruition, the costs to commercial real estate lenders will increase.
As we have said many times over the years, when a storm hits, you want to be as far away from the eye as possible. If you want to go bargain hunting, wait for the storm to clear and then sift among the pieces. This storm, entirely tied to tight money and higher interest rates, is far from over. It will extend beyond commercial real estate. Default rates of low-quality auto loans are rising rapidly. Credit card borrowers may now be paying over 20% on their money. With unemployment at 3.4%, that is still manageable. But what happens if unemployment rises?
That brings me back to the stock market. It has had a pretty good run the past two months. The Fed seems near the end of its rate hiking cycle. There’s a growing feeling that a true recession just might be averted. The debt ceiling crisis is a near-term issue but most expect it to be resolved without a true default. To the optimists, there are hints of blue skies ahead.
But wait. Markets are still within their 12-month trading range. The surge to date has been led by high multiple stocks and long yields declining down to about 3.3% from a peak of 4.25%. But those yields have started to climb again signaling that multiple expansion may be over for now. Treasury will flood the markets with new debt as soon as the Fed continues to sell assets off its balance sheet. More sellers than buyers almost always mean lower prices. That means higher yields, never a friend of equity investors. Leadership the past several months has been narrow. Earnings estimates are coming down. For those whose fortunes are improving near-term, higher earnings are a derivative of cost cutting, not accelerating revenues. Many expect that a favorable resolution to the debt ceiling crisis and the possibility that the Fed has finished raising interest rates means clear skies are coming. But not so fast. Earnings are falling. Interest rates have been rising and could climb higher. That isn’t a formula for rising stock prices. Markets rarely do what the consensus believes. Perhaps an outlook for a choppy market ahead is a more sober conclusion.
Today, character actor John C. Reilly is 56. Bob Dylan turns 82.
James M. Meyer, CFA 610-260-2220