Why Couldn’t the Experts Spot the Impact That Withdrawing Cheap Borrowing Would Have on Equity Markets?

Zahir Shah  |


“Addicted to cheap debt” has been a phrase repeated constantly in the mainstream financial media as stock markets slumped globally. “The end of cheap debt” likewise. These observations weren’t ground breaking revelations, Q.E. ended in the USA in 2015, interest rates doubled in 2017; from 0.75% to 1.5%. Monetary easing in the USA, where the equities sell off began, had been reined in very carefully, skillfully and visibly during Janet Yellen’s time as the chair of the Fed. Doubling interest rates in 2017 should have delivered a message to corporations that their method to inflate their share price, buying back their own shares with cheap loans, creating scarcity, thereby inflating the price, was now finished as an activity.

Figures vary on the amount of corporate borrowing amongst quoted firms that quickly found its way back into the stock market, the general consensus is a figure between 80-95%. It’s quite a stunning revelation, the realization that rather than invest in labor, technology, plant and machinery, or innovation, hundreds (if not thousands) of the leading corporations simply used their available credit lines to boost their share price, by buying their own equity. The wasted opportunity is incalculable, trillions of dollars of misallocated capital that failed to stimulate the real economy, instead it created a bubble in equity markets. Across the board the four main equity markets in the USA rose by circa 30% in 2017. The NASDAQ by close on 40%, certain FAANG stocks by approx. 50%. The rises were not due to improved earnings or performance, or due to a noticeably improving economy, the trickle down into the productive economy was scarce, the wealth effect nonexistent.

Despite the cost of borrowing rising, equity markets enjoyed a huge stimulus in 2017 as markets banked on Trump’s obsession to lower corporate tax rates finally becoming law. Analysts and investors quickly crunched the numbers and quantified what would be the benefits of reducing the key rate from 35% to 21% on share prices and dividends. However, perhaps industry experts overestimated the impact, as the vast majority of corporates don’t pay 35%, certain estimates suggest the on average tax bill is closer to 15%. The anticipation of the tax cuts in December helped USA markets to rise by circa 5% during the month. In a four month period, from mid-September to mid-January, the USA DJIA rose from the critical handle of 22,000, to 26,600, in percentage terms a rise of close on 21%.

It’s noticeable that during such a four month spike, unprecedented in the modern era, there were no alarms bells sounded by the mainstream financial media. Hardly any dissenting voices could be heard across the full spectrum of media outlets calling out such a rally for what it was - a bubble that might burst. It appeared that far too many outlets were too cowed and fearful of standing up to point at the absurdity of such a rise. What is noticeable is the many hindsight experts who’ve suddenly emerged to preach as to how the correction, the much needed pullback, was so obvious.

For a close on four month period analysts and economists began their commentaries with the introduction of “yet another record high for USA markets” and there were hardly any experts invited to suggest caution and those that did were quickly railroaded by the interviewer.

It’s not that the experts couldn’t spot the bubble, but that their voices were ignored and drowned out by the media channels who were desperate to peddle the good news angle of an ever inflating market. Similar to the crises witnessed in 2007/2008, before the events there were many analysts warning that the USA housing market was ridiculously overvalued, underpinned by reckless lending and equally reckless borrowing and set for a crash. Perhaps it’s incumbent for traders and investors to do their own research, to ensure they’re prepared, forearmed and forewarned.

Story Contribution: Senior market analysts from FXCC contributed in this story.

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