What Happens When All the Corporate Debt Rolls Over?

Podcast Transcript

Ed Coyne: Hello and welcome to Sprott Radio. I'm your host, Ed Coyne, Senior Managing Partner at Sprott Asset Management. I'm pleased today to welcome Stephanie Pomboy, founder of MacroMavens. Stephanie, thank you for joining Sprott Radio.

Stephanie Pomboy: Thanks so much for having me, Ed. I'm excited to be here.

Ed Coyne: We're excited to have you. Stephanie. Before we unpack the most recent Fed meeting and market trends in general, I thought it'd be interesting for our listeners to hear a bit about yourself and the company you started in 2002.

Stephanie Pomboy: Okay. Well, I'm looking forward to talking about the Fed. Talking about myself is my least favorite, so I'll make it brief. Yes, I started MacroMavens, an independent macroeconomic research firm, in 2002, so it's been over two decades already. My self-imposed mandate is to identify areas where, let's say, perception has strayed from reality.

The best investment opportunities always lie around areas where the market is mispricing the most likely outcome. My way of going about that is looking into the nitty-gritty details of the economic data and coming up with a conclusion as to what's going on in the economy and where we're likely headed, and then looking at the markets and figuring out where they're not pricing in that likely outcome appropriately. That's what I do in a nutshell.

Ed Coyne: You tend to get it right more often than not, and you talk about identifying those global economic trends ahead of the curve. What are some of the secret sauces, as it were? Is it meeting with CEOs? Is it talking to analysts and economists? What is your network? If you don't mind letting us behind the curtain a bit, how do you try to identify those trends and stay ahead of the curve?

Stephanie Pomboy: Well, it's embarrassingly simple. I have to credit Wall Street with creating this career for me because few people do basic analysis anymore. The company analysts take whatever the companies tell them verbatim, accept that as the gold standard, and don't do their own analysis. The rest of Wall Street more broadly places analysis secondary to their profit motive.

I hate to be cynical about it, but most people on Wall Street are paid to tell you that everything will be great forever and that you should always buy stocks and this and that. Maybe occasionally, you want to churn from one sector to the other to generate some commissions, although that's less of a thing now. Research is the monkey on the back of the deal-making engine for Wall Street.

It's a long way of saying, "Basically, I just look at the data." I'm a nerd, so I sit there, and every time some economic data point comes out, I don't just take the headline and seize on that as the gospel. I go in and look at the details and sift through stupid things like, "Are they playing with seasonal adjustment factors to tweak these numbers and make them look better, or how does this compare to prior episodes, et cetera?" It's actually just basic analysis, which shouldn't be such a rarity, but thank God it is on Wall Street, and therefore, I have this nice little niche that I've been able to exploit.

Ed Coyne: Well, to sum it up, you're doing the work, right? You said something interesting earlier: the perception of what's happening in the market. Everybody has a narrative out there, whether it's a CEO or a news media, but then there's the reality, which can be very harsh. What's happening when you put that light on a real balance sheet?

Talk a little bit more about that. At what point do you realize, "Gee, this is not the reality; what's happening, and I need to tell that to my people?" What is that? What's that spark that happens when you're looking at the economy or looking at balance sheets?

Stephanie Pomboy: Well, one of the most fascinating episodes for me was the Global Financial Crisis. It was just a few years after I had gotten started. I started in 2002, and one of the first things I started writing about was the housing bubble. My first piece was called The Great Bubble Transfer, and it talked about how the Fed, after inflating and bursting the dot-com bubble, was now trying to re-inflate a bubble in the real estate market to numb the pain of that disaster.

Sure enough, this bubble started inflating through 2002, 2003, and 2004. As I watched it inflate, I started working on, "Okay, what's going to happen when this invariably goes bust, which it will?" We started talking about "Who's going to be left holding the bag when the housing bubble goes bust? The obvious thing is the homeowners will get screwed, but let's look at the other side of the coin. Who's lending them the money?"

I remember going to major institutions like Fidelity Mutual Funds and all these big fund complexes and sitting around a table with their bank analysts. I would say, "You realize that this financial sector has record exposure to the residential real estate market." They all insisted up, down, and sideways that, no, the banks had offloaded all of their exposure. They had cleverly packaged it all up and securitized it, and sold it to some schmuck as a pension.

That was all true. They didn't realize that they were investing in somebody else's mortgage-backed security on the other side of the bank. Yes, they may have securitized the loans that they were making, but they then turned around and used the proceeds to buy other manufactured toxic paper. It's that kind of thing where if you look at the data, you can look at and see, well, commercial bank holdings of mortgage-backed securities were at an all-time record.

The popular narrative that the banks had offloaded all the risk and, therefore would be fine was just embraced as gospel without any real analysis. People just accepted it like they do today. The consumer is strong. You cannot turn on CNBC or Fox Business or whatever your financial media source is without hearing that catchline just thrown out like it's a matter of fact. You won't be surprised to learn, Ed, that when I look at all the economic data around the consumer, I come away with a starkly different picture of just how strong the consumer is.

That's just one example of where perception can run far away from reality, and then, obviously, having been in the business for a while, you get into these new-era paradigm narratives where everyone says, "Oh, well, this time is going to be different because X, Y, Z is this one-off factor that's transforming the landscape and makes analyzing this through the usual parameters impossible." Whenever you hear that kind of stuff, bells go off in my head like, "Okay, well, that's probably not going to be the case."

Ed Coyne: Well, let's shift gears because I know this is a topic you love to talk about, which is the Fed. The first question I'd ask you is, is it possible they may be getting it right?

Stephanie Pomboy: No.

Ed Coyne: Okay. End the podcast.

Stephanie Pomboy: I wanted to give a moment of hesitation, but no. Of course, yes, it's possible, but it would be the first time in the history of the Federal Reserve that they had gotten something right. I have very little hope that that's the case, and I think, if anything, this will probably prove to be one of their most spectacular blunders. It's interesting because it's a study in human psychology.

You would think on paper, if you said to someone, "Here's an economy that has twice as much debt as it did in 2008 and a corporate sector in particular that has twice as much debt as it did in 2008, and the Federal Reserve just took rates up far higher, far faster than it did back then. Do you think there's a probability that we will get by with no recession or even a landing?"

Intuitively, you would say, "That's ridiculous. That can't happen." We've gotten into this situation now where each day that goes by and we don't have that accident, people become more confident that it's never going to come. Meanwhile, each day, you're getting closer and closer to the moment when it is going to impact. It's an interesting study of human psychology.

I'll eat my hat if it turns out that the accident ever comes, and the Fed has engineered this perfect no-landing and, in the process, managed to return interest rates to a level that is a more normal level for interest rates.

Ed Coyne: Well, those are two things I want to dive into: debt and rates. Let's start with debt. It just doesn't matter how much debt you have relative to how much income you bring in, whether it's an individual person or a corporation. Does debt matter anymore today, or can you refinance and refinance and run that cycle?

Stephanie Pomboy: It's such a fascinating question because the bee in my bonnet the whole time since the Fed started raising rates has obviously been the struggle that both consumers and corporations would have in servicing debt at these higher rates. We've gone a year and a half, and it's true: we've seen an increase in delinquencies on the consumer side, credit card delinquencies and the same with the subprime auto segment.

They've all picked up materially. On the corporate side, you have seen a huge increase in bankruptcy filings, but you have yet to see a real default cycle in the corporate market the way I anticipated we would. I've been trying to scratch my head as to why it's taking so long for this to happen. If you were a junk-rated borrower, you borrowed at 4% before the Fed started raising rates.

On my screen today, that yield is 9%. Suppose you are borrowing at 4%, and you have to roll that paper at 9%. In that case, you're more than doubling your debt service, which might be tolerable in an environment where the economy is hitting on all cylinders and everything's great. Still, however, you might want to characterize the economy today, I don't think that's how most people would describe it.

I'm puzzled as to why we haven't seen more issues there and certainly haven't seen any widening of credit spreads or a sense of real risk aversion in the credit markets. What I've discovered, which sends chills down my spine, is that I think the reason why they are managing to roll this paper at these higher rates and service their debt, pay this onerous increase in debt service, is that they're borrowing more to do so.

I'm constantly clipping articles on this, but one talked about how more companies are going to PIKs, the Payment In Kind. They're layering debt on top of debt, and it's similar to what you're seeing in the consumer space where consumers, as they got stretched during the COVID pandemic, paid down credit card balances with all the money they were getting from Washington.

Then, they slowly increased their credit card balances again when that dried up. Then we got into a period where, as inflation picked up and the cost of everything started to go up, they really ramped up their credit card borrowing and did so at 22% interest rates. We've never seen interest rates like this. That's another sign of clear distress, but they're doing everything possible.

They're like that trite analogy of the roadrunner off the edge of the cliff, and their legs are spinning, and they're just desperate to maintain this lifestyle that's so out of reach. You're seeing the same thing on the corporate side with these PIKs, which also come at usurious payday loan type of interest rates. Still, the whole idea is if we can make it to the other side, if we can get through this rough patch to the soft landing or no landing and the economic recovery, it'll all be fine.

It's interesting to me because I describe it as it's not just Wall Street that is betting on the Fed pivot; it's Main Street because they're all wagering heavily that those high interest rates are the anomaly and that we're going to go back to that world where money was free again. Hence, they need to suck it up for a few months, and then they'll be able to ReFi at much lower rates. It's a massive gamble.

Ed Coyne: It was interesting you talked about the rates for a moment because it seems like corporations and consumers are now trying to operate or manage their balance sheets the way the U.S. government does, which is just borrowing more money. They can get away with it. They have tanks and planes; we don't. We have to pay back our debt. It'll be interesting to see how that plays out, but our rates here are higher rates here to stay. What does that other side look like? Does it exist?

Stephanie Pomboy: Great questions all. The answer to that involves distinguishing between the different markets because, as you said, it's one thing for the government to borrow money infinitely. They have a printing press and the power of taxation. The companies don't, and consumers don't, so it's a much more urgent issue for them. I could see a scenario where you have, let's say, in my view, you won't be shocked to know, I think we have a hard landing, and therefore, the Fed does end up cutting rates and treasury yields in the whole treasury complex probably moves lower in yield.

You see reprieve on the government funding side, but that is precisely when the credit spread below it that I've been anticipating would finally start to happen. The cost for private borrowers would continue to go up. We see this every time we have a recession scenario where the credit tightening begins in earnest once the Fed panics, realizes they've overdone it, and starts to cut.

That's when you want to sell. Everyone thinks, "Okay, when the pivot comes, everything will be great." No, it's the anticipation of the pivot, and when it happens, you want to be heading for the hills. My answer to your question is higher for longer, I think, will indeed be the case in the private markets for consumers and corporations. But it is not likely to be the case for the government because, in addition to the eroding economy, the Fed will probably end up re-upping QE as part of its new effort to stimulate. They'll become the marginal buyer or treasuries again, and we'll see those yields head sharply lower.

Ed Coyne: I'll throw out another possibility, which you and I briefly discussed before starting the podcast. Is there a possibility that we could have a sector-by-sector or industry-by-industry soft or hard landing? Depending on how you define that, given people's access to credit and who can get it and who can't, is that a possibility? Do you see this somewhere in between?

Stephanie Pomboy: Yes. My concern is that what generally happens is the stresses start at the weakest links in the credit chain, and they bleed out from there. For example, during the housing crisis, you had the most levered structures, including the residential mortgage, and those things broke first. Then, you started to move out the chain from the subprime highly leveraged structures up to prime. Then, of course, everything else, even the corporate sector, even though that wasn't the problem, saw spreads and yields blow out.

While we like to imagine that something can be isolated and contained, to use the famous phrase, to the specific problem, risk-off tends to be pervasive, and creditors get gun-shy and say, "Look, I am not ready to extend credit anywhere." Could it be different this time? I guess, but I think my money, since I'm conservative, would be to bet on history repeating and that, if anything, the risk-off impulse this time might be even more urgent.

Because people got so lax here as they watched the Fed pursue this unprecedented tightening and persuaded themselves that nothing bad would happen and doubled down effectively, I think it could be a bigger, broader hit. I'd be reluctant to think it would be a rolling thing, but I'm certainly open to that possibility. I'll watch it and see.

Ed Coyne: Well, what about from an investor's standpoint then? There seem to be many potholes on the road these days just talking about it from a debt and economic slowdown standpoint. Where are some of the potential bright spots out there for someone who must invest additional capital into the market and is still building their nest eggs? What can someone do with their money today rather than continue to allocate to the market in a smart, thoughtful way?

Stephanie Pomboy: Well, I guess the first thing I would say is cash looks pretty damn good right now. Don't feel you need to be a hero and identify the next great thing in the market. You're being paid to sit back and watch and see how this situation unfolds. Whether the Fed is going to pull off, for the first time, this perfect landing, in which case, there'll be a lot of opportunity to get in there.

In the meantime, you're getting 5% or 5.5%, depending on where on the treasury curve you want to be to sit and wait and gather more information. I happen to think cash is a very compelling investment opportunity right now. Other than that, we're also probably getting toward the peak in the long-dated treasury yields. You could, if you wanted to, start building a position at the long end of the curve, with last Friday's payroll employment reports being the first in what I believe will be a parade of disappointing data like that, but again, you could also hunker down in the front end of the curve and bank the 5% and be very happy.

Other than that, I think I'm extremely bullish on the precious metals because I believe that this is going to be a very hard landing that will "require," and I use that in quotes, the Fed to have a very aggressive monetary stimulus response that we'll see them re-upping QE and probably in a fashion that makes 2008-'09 look relatively mild. That's one of my more radical views, but if I'm anywhere close to right, I think gold will do well in that scenario.

Then, that's before even talking about the secular shift by BRICS+ nations and the world in general away from the dollar into gold. I don't need to tell you that central banks have been accumulating gold in record fashion. I don't think that's an accident. I like the precious metals, and I even happen to like the gold miners. I think we’ve got to be getting close to a turning point there. Oil and energy producers, nothing about our domestic energy policy makes me think that oil prices are going to move sharply lower anytime soon or stay there.

Looking around the world these days and what's happening geopolitically, I think oil's probably a pretty good place to be. I have a preference for emerging markets, but I have been burned many times in the risk-off frenzy in thinking that, "Well, people will finally distinguish between the developed world debtor nations that have all the issues and the emerging world creditor issues that have better demographics and are not creditor nations," but they don't.

It's like a Pavlovian response. If we're going into a recession, they think the emerging markets will disappear from the face of the earth now. I'd be waiting and watching how that plays out, but I'd be ready to pounce into emerging markets if it looked like we were starting to see some decoupling, let's say. Then, in terms of things that I would avoid, consumer discretionary, which I think will get pummeled.

I just looked this morning, and next year's consensus S&P earnings estimate is 10% growth for consumer discretionary, which is probably the right number but in the wrong direction. On the corporate credit side, I would just be steering far away from corporate credit. People will say, "Well, there's a great opportunity and investment grade."

Again, for the reasons we discussed, where things don't remain isolated and contained, I would not be interested in what looks like high-quality paper because I think the baby will get thrown out with the bath water there. Frankly, the investment-grade market isn't what it used to be. 50% of the investment grade bond market is one downgrade away from junk anyway, so it's just pretending to be investment grade but dangling on by a thread. Those are just some of my big-picture topics.

Ed Coyne: Well, that's a full basket for sure. There is some hope. There is some hope you can still put money to work, which is good. I know you get a lot of requests to speak and be on news media and so forth. I appreciate you taking the time to join us on Sprott Radio. Before we sign off, though, is there anything that I didn't ask that might be of interest or something you want to convey to the group or our listeners?

Stephanie Pomboy: Yes. Well, first, I want to thank you for having me on this Sprott podcast. Sprott is very near and dear to my heart regarding my personal asset allocation to precious metals. I tell everyone that this is the best way to do it.

Things that we didn't touch on? We covered pretty much everything. I guess if there were one thing that I'd underscore, and I know it's not a popular view, is this shift away from the dollar that seems to be accelerating is something that I think gets too cavalierly dismissed.

There's this sense that there is no alternative to the dollar, just like there used to be no alternative to stocks. All evidence exists to the contrary. We're seeing every day central banks diversify out of dollars into gold. It's not an issue immediately, but if the hard-landing scenario that I describe comes to pass and we go through a 2008-'09-style downturn and the Fed is forced to come in and inject this kind of monster amount of liquidity all over again, it could be a very different dynamic for the dollar because the rest of the world is already saying, "It's enough with all this reckless monetary and fiscal stimulus."

That's now while the Fed is, in theory, unwinding its balance sheet and trying to be slightly more responsible. It's something that I would be very alert to and stay focused on because it's not what's happening today but what could happen over the next 12 or 18 months. Something like that.

Ed Coyne: Listen, this was great. I would tell all the listeners out there if you'd like to learn more about what Stephanie Pomboy is up to at MacroMavens. They have a great website talking about some different things there. You can subscribe to that website for more in-depth knowledge of Stephanie's thoughts. You can reach their group at macromavens.com. I encourage you to do that. Once again, I'm your host, Ed Coyne. Thank you all for listening to Sprott Radio.