Crispin Odey's Complaint of Zombies and Fairy Dust Has a Point
(Bloomberg Gadfly) -- Out of the mouths of babes and sucklings, wisdom can sometimes be heard. The same applies to money-losing hedge-fund managers.
In his most recent letter to his long-suffering investors, Crispin Odey accuses banks of keeping unprofitable companies alive by sprinkling them with the "fairy dust" of easy finance. His track record in the past few years -- his European long-short equity fund lost more than 20 percent last year, after declining by almost 50 percent in 2016 -- might lead some to dismiss his comments as sour grapes.
But the data on junk-rated borrowers offers compelling evidence that Odey is correct.
Just 12 companies had the misfortune to become "fallen angels" last year by being downgraded to junk status from investment grade, Moody's Investors Service said on Monday. That's the lowest tally since 2010, the credit rating company said.
Put another way, out of the 6,500-plus companies in the lowest investment-grade category of Baa, financial Darwinism selected just a dozen borrowers for downgrade in 2017. That's an incredible statistic.
The most obvious explanation is the widespread availability of easy money. Junk-rated borrowers pay interest of about 5.2 percent, based on the average yield for the Bloomberg Barclays Global High-Yield index, which covers 3,435 borrowers with $2.65 trillion of debt. That's close to the record low of 4.9 percent set in 2014, and well below the 15-year average of 8 percent.
Moreover, Claudio Borio, head of the monetary and economic department at the Bank for International Settlements, agrees with Odey that banks are unwilling to pull the plug on zombie borrowers:
Banks with impaired balance sheets and high non-performing loans have strong incentives not to recognize losses and to mis-allocate credit: they will tend to keep the spigots open for weaker borrowers (“evergreening”) while curtailing or increasing the cost of credit to healthier ones, which can afford to pay.
In a speech in Paris last week, Borio cited research by the Organization for Economic Cooperation and Development suggesting zombie companies -- defined as those with 10 years or more of history and whose earnings are less than their debt interest payments -- comprise more than 10 percent of publicly traded companies in the world's biggest economies. That's up from less than 2 percent in 1990.
What's more worrying is their longevity; more than 80 percent are likely to remain in the zombie category in the following year, up from less than 60 percent in 1993. Borio argued that weak companies have less incentive to reduce debt when interest rates are low. That in turn leads to resource mis-allocation, with capital trapped in unproductive firms.
With money still cheap, the universe of coffin-dodging borrowers is likely to increase. Moody's predicts that default rates for the lowest-grade credits will continue to decline for the rest of this year.
As correct as Odey may be about banks keeping undead companies alive, his investment thesis that stocks will suffer as central banks drain the punch bowl of monetary liquidity currently looks wrong.
The European Central Bank has halved its monthly government bond buying and looks poised to halt purchases entirely by the end of the third quarter; the Bank of England snuck in an interest rate rise toward the end of last year. Meantime, the Federal Reserve has lifted rates five times, and looks set to add three or four more increases this year. Here's what's happened to the MSCI World Index of global stocks since the U.S. central bank embarked on the path toward policy normalization.
The International Monetary Fund just raised its global growth forecasts for this year and next to 3.9 percent, an increase of 0.2 points from its October forecasts for both years. With the world economy enjoying a synchronized growth spurt, the outlook for corporate profit continues to improve.
And if stock markets continue to party, the real zombies may turn out to be those hedge-fund managers who persist in betting against the trend.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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