Market Perspective – April 2016

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Overview: Since the financial crisis began, central banks around the world have stressed easy monetary policy. Accordingly, historically low interest rates created a dramatic increase in debt levels. This month we look deeper at the potential consequences and impact of loose monetary policy which has driven this proliferation of debt. We also investigate the impact of capital allocation as it relates to this phenomenon.

Yields Remain Near Historical Lows

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• As you can see from the chart, the 10 Year U.S. Treasury yield remains under 1.8%, leaving debt issuances very attractive for borrowers.

• Yields around the globe are near historical lows and in some cases, actually negative.

• With the cost of debt low, many companies and governments have issued additional debt.

Increasing Government Leverage

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• Providing ample liquidity and keeping interest rates at historical lows helped lift the U.S. economy out of the Great Recession.

• However, U.S. Government debt has ballooned from $8 trillion in 2008 to $19 trillion in 2015.

• Federal Reserve debt during this timeframe rose from $800 billion to $5 trillion.

• As shown in the adjacent chart, this extended easy money policy has pushed U.S. Treasury Debt to GDP up to over 22%, the highest level in the post-WWII period.

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Long-Term Treasury Debt/GDP

Source: Federal Reserve Bank of St. Louis

Corporate Leverage is Also at Multi-Decade Highs

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• Near-zero interest rates are also giving Companies strong incentives to borrow. Low cost of debt creates correspondingly low hurdle rates on activities such as M&A, dividends and share buybacks.

• As a result, corporate leverage has surpassed the levels hit in the financial crisis' aftermath. As shown in this chart, median leverage for investment grade (non-Financial and excluding Utilities) companies has increased meaningfully. For high yield companies, the median leverage is more than 4.3x companies’ EBITDA.

Gross Leverage for Investment Grade and High Yield Companies

Use of Proceeds: Share Buybacks

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• Easy access to capital often results in misallocation of that capital, which in turn can create artificial and/or temporary demand. Many companies have used debt to fuel an unprecedented, relentless share buyback.

• The positive result of repurchasing stock is a boost to earnings due to shrinking the common share count in the denominator of earnings per share. However, this type of growth can be considered a form of financial engineering rather than demand based.

• Additional problems are created in that when a company uses capital to repurchase shares, it forgoes the opportunity to use that capital for investment in capital equipment, research and development, and investment in future growth.

Share Repurchases Supporting Equity Markets

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• Corporate share repurchase rates have reached a post-crisis high. As of Feb 6th, the S&P 500 buyback authorizations have exceeded $60B, one of the largest starts on record.

• As shown in this chart, this is a part of a long-term trend as corporations are the largest and growing source of equity inflows.

• However, corporate foresight is far from perfect. For example, the largest year on record for buybacks was 2007, just before the market plunged.

Buybacks Remain the Largest Source of Demand for US Equities

Conclusion: Debt levels continue to mushroom as countries and companies around the world take advantage of very low or even negative interest rates. Due to the high leverage and the uncertainty surrounding policy solutions, seemingly minor events (such as the Fed decisions to change rates by nominal amounts) are causing massive movements in global markets. We continue to cautiously monitor these trends for opportunities to invest capital in situations which maintain attractive risk/reward characteristics.

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Market Perspective – April 2016

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Disclaimer

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Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy.