Hordes of zombie companies are about to die

In the AFR I write that this column been much more constructive on risk since late May when we determined that interest rate markets were finally pricing in the monetary policy tightening required to deal with the near-term inflation threat coupled with our central case that consumer price pressures would start dissipating as supply chains normalised.

I want to make clear that we are not, as a consequence, bullish on the macro outlook. Our core view remains that the US economy tumbles into some sort of recession and that global activity data continues to sour.

As the cost of capital associated with sub-prime finance soars, many borrowers who could not get finance from the traditional banking system will face the spectre of default. 

It would appear that while equities have appropriately responded to the regime change in long-term interest rates (or discount rates), there are continuing vulnerabilities regarding earnings expectations.

The long and variable lags inherent in monetary policy tightening cycles mean that it is inevitable that in the first phase of that process we see large cross-currents in data releases that have something for everyone.

This has been evident in Australia in the contradictions in the household and business survey data. If you are myopic and have your head buried in the sand, you will attach more weight to the business surveys that suggest the economy is just fine.

If you are half-smart, you will focus on the fact that borrowers have only experienced one to two of the Reserve Bank of Australia’s four interest rate increases since May due to delays in the banks’ operational implementation of changes to borrowers’ actual repayments. This explains why consumer spending seems OK — and hence business revenues remain robust — while consumer confidence is at recessionary levels.

While borrowers know that the wolf is at their door, they have yet to have their cash flows materially impacted. The disappointing official wage price index data released this week confirmed what this column had been arguing for months: there is no evidence of either a wage-price spiral or generalised wage growth that would give the RBA pause in relation to its future inflation expectations.

In the June quarter, the wage price index disappointed market forecasts, printing at only 0.7 per cent (compared to the 0.8 per cent prediction) and by just 2.6 per cent over the last 12 months (underclubbing consensus calls for a 2.7 per cent outcome). The broader market or trader bias was towards an upside surprise with the wage numbers, which failed to materialise.

While some economists will criticise the compositionally-adjusted office wage results, they crucially conform almost exactly with CBA’s wage index, which tracks actual income payments into 300,000 bank accounts.

Since the pandemic, the RBA made a big deal of the claim that it needed to see wage growth of 3-4 per cent annually to be confident it could secure “sustainable” inflation within its target 2-3 per cent band.

And yet since the actual wage outcomes do not conform with its new narrative around pre-emptive, forecast-based interest rate increases motivated to combat an ephemeral and nebulous inflation expectations threat, Martin Place has simply stopped referencing the official wage data. Instead, it keeps on referring to its internal “liaison” data, which is code for “fake it until you make it”.

The best real-time, daily data that we have on the macroeconomy are the compositionally-adjusted (or hedonic) house price indices reported by CoreLogic. And the story they are telling is crystal-clear: the entire east coast of Australia, which accounts for the vast majority of the population, is experiencing a record housing collapse that is only likely to get worse given most borrowers have yet to feel much in the way of mortgage repayment pain.

The big news in August is that the Brisbane and Gold Coast housing markets have given up the ghost after defying gravity for a few months. Adelaide is not far behind. In the first 18 days of August, the 0.74 per cent decline in Brisbane house prices has outpaced the 0.67 per cent loss suffered in Melbourne.

Sydney remains the epicentre of the housing crash, with dwelling values slumping another 1.24 per cent in the first 18 days of the month. Home values in Australia’s largest city have plunged 6.5 per cent in 2022. They have been falling at a 19 per cent annualised rate since the RBA’s first rate increase at the start of May.

I know these facts are uncomfortable for property spruikers to hear, but there is little point denying that Aussie housing is likely to weather its largest correction since records began in the early 1980s (as we forecast in October last year). Banks like ANZ have belatedly arrived at the same opinion.

Across the five biggest capital cities, house prices are only melting at a 12 per cent annualised pace, which is orderly in the scheme of things, although this should accelerate as conditions in cities like Adelaide, Brisbane and Perth inexorably weaken.

Another silver lining is that Melbourne dwelling values are only losing altitude at a more modest 13 per cent annualised rate compared to deeper drawdowns in Sydney. Since its peak earlier in the year, Melbourne housing has lost 4.1 per cent while the national market is off about 3.6 per cent.

As this column asserted last year, this is only modest payback compared to the 37 percentage points of capital gains homeowners earned in the period following June 2019 when the RBA’s cash rate was 1.5 per cent (it was slashed to 0.1 per cent by November 2020). But what Martin Place giveth, it now taketh away.

In our own portfolios, the strategy has been pretty straightforward. We monetised about $8.2 billion of shorts between late 2021 and mid-2022 in US, European and Australian credit based on the belief that credit spreads would push about 100 basis points wider. After this came to pass, we have shifted to buying credit once again, focussing on the cheapest sector we can identify, which has been bank-issued Tier 2 bonds. Since May, we have bought about $815 million of Tier 2, which has started to perform.

The outlook nonetheless remains complex given our dour forecasts for a sharp further deceleration in the real economy. Since December 2021, we have argued that investors should prepare for the first inflation- and interest rate-led default cycle since the 1991 recession. There are hordes of zombie companies that have had their business models predicated on the availability of cheap money, which no longer exists.

Many of these borrowers relied on the high-yield or sub-investment grade bond markets for liquidity. As the cost of capital associated with sub-prime finance soars, many borrowers that could not get finance from the traditional banking system will face the spectre of default.

A parallel problem for the high-yield bond market is the outright level of credit spreads and interest rates in the much safer and more liquid investment-grade market. If you can get 6 per cent interest rates on five-year, BBB+ rated bonds issued by NAB and ANZ, why would you bother buying much riskier and less liquid high-yield securities offering similar returns?

We have also been quite negative on the residential-mortgage-backed securities (RMBS) market since last year. RMBS will be very adversely impacted by the record decline in house prices, which mechanically forces up the loan-to-value ratios (and risk) of the home loans backing these bonds. RMBS will also inevitably suffer from a material spike in mortgage default rates, which will probably not emerge in the data for another six to 12 months. Finally, the complexity of RMBS cash-flow repayment profiles means that secondary liquidity for these bonds is poor.

What we need to see is a big repricing of the illiquidity risk premia associated with RMBS in the form of wider credit spreads. At some point, these spreads will become sufficiently compelling to attract new capital. But there is much wood to chop in the meantime, especially because most non-bank lenders have no other way to raise money to finance their operations.

The truth is that some of these zombie non-banks will have to disappear, merged into banks or more profitable non-bank peers. Their business models may not be viable in a world where their cost of capital is being properly priced.