“Without savings we don’t have the capacity to make physical investment,” Hunt argued. “Without physical investment, we do not have the capacity to grow over time and raise our standard of living.”
The twin problems of debt and demographics are even worse in Japan and Europe, he argued. Although the productivity of every marginal dollar of debt issued in the U.S. has declined from 50 cents to 40 cents over the last two decades, it currently stands at 20 cents in Japan. For this reason, the dollar is likely to remain strong.
Rescue Capital
America’s Big Tech and Big Pharma industries have weathered their share of criticism in recent years but, for some strange reason, everyone suddenly is looking to the drug companies for a way to save society. Less obvious is the nation’s financial services companies, which are offering creative ways for shuttered businesses to stay alive.
Nowhere is this more obvious than in the convertible bond market. Every week since late March, a list of companies like Southwest Airlines, Carnival Cruise Line and Dick’s Sporting Goods have issued converts, and the market has been receptive.
Until the pandemic struck, the convertible bond market had served in recent years as a source of capital for emerging growth companies in industries like software and biotech that lacked the earnings to issue investment-grade debt and didn’t want to sell more equity because it would cause dilution. That all changed after the Fed indicated in late March it would backstop the credit markets, according to Dave King, lead manager of the Columbia Convertible Securities Fund.
As King describes it, a company with shuttered stores like Dick’s Sporting Goods chose to eliminate its dividend and issue convertible debt at 3.25% that converts into equity at a premium, say 30% or 40% higher than the current price. The business can simultaneously reduce its cost of capital while only giving up equity if its shares appreciate significantly off their depressed levels.
If the stock appreciates, bondholders can convert their shares into equity, and the contingent equity eliminates a big chunk of debt. Carnival Cruise opted to do a complete recapitalization, selling convertibles along with straight debt and equity, and its bonds climbed nearly 50%. That “greased the wheels for Norwegian Cruise Line,” says Craig Manchuck, who manages Osterweis’s Strategic Income Fund.
Critics can argue all they want about how financial engineering displaced innovation in corporate America, ultimately to the nation’s detriment. Several speakers at Mauldin’s event noted that American companies have seen no growth in real economic profits since 2014. All the expansion in earnings per share has come from financial maneuvers like buybacks and tax cuts. Mike Wilson, chief market strategist at Morgan Stanley, described the earnings gains following the reduction in corporate tax rates in 2018 as the poorest quality earnings gains he’d seen in a long time.
But what’s happening in the convertible stock arena shows that private markets can play an important role in salvaging the economy. A company concerned about exhausting its debt capacity and getting overleveraged can get junior capital and look to expand its equity base. Sometimes imaginative financing can provide better outcomes than subprime mortgages did 12 years ago.
Unknown Unknowns
How this MMT experiment ends is anyone’s guess. But with trillions being pumped into most sectors of the economy, bad investments and misallocation of capital are inevitable.
Many of the wise men at Mauldin’s conference are predicting an anemic, painful recovery with full employment taking the better part of a decade to return. Still, it’s worth noting that the Spanish flu in 1918 and 1919 was followed by a nasty recession sometimes called the Forgotten Depression. What came next? The Roaring Twenties.