Raoul Pal is a former hedge fund manager who retired at age 36 but remains actively involved in the world of macroeconomics and finance. In recent years, he started a finance news and content service called Real Vision.
In a video posted on YouTube on August 14th, Pal discusses his case for a recession in the next year or so as well as a very alarming scenario he calls the “doom loop.” It’s a fascinating and frightening thesis, and I find it persuasive. Here’s the line of reasoning:
(1) The Fed lowers interest rates to stimulate the economy through increased lending. How else are lower interest rates supposed to stimulate anything besides through more lending, i.e. more debt?
(2) As a result, all sorts of market and government actors increase their debt loads. Corporations, especially, took advantage of falling rates to refinance and take on more debt.
(3) Some of this debt buildup has been for acquisitions or mega-mergers, but much of it was taken on simply for share buybacks. See, for instance, this chart showing the way in which debt issuance and share buybacks became tightly correlated right around the time that the Fed Funds rate bottomed near zero. (See my article addressing this subject here.)
Source: Hussman Funds
Debt-funded buybacks have served as a convenient way for corporate executives to lift earnings per share, thus meeting guidance more regularly and reaching the targets for their performance bonuses more often. (I wrote about this subject here.) What’s more, an SEC study found that insider selling tended to coincide with the announcements or implementation of buybacks.
(4) Indeed, if you look at the performance of U.S. stocks versus any other country or world region’s stocks, you’ll notice a stark difference. U.S. stocks have soared ahead of the competition. It turns out that this is largely because of buybacks, as corporations themselves have been the biggest net buyers of corporate stock since the Great Recession:
Source: Avondale Partners
Notice that institutions (including pension funds) have been net sellers of U.S. equities since the recession. This likely means that pensions have been forced to sell many of their assets to fund benefit payouts but have sold other assets such as Treasuries at a faster rate than equities.
(5) Who is buying all this debt being issued to fund buybacks? The answer, in large part, is pensions. Mainly corporate pensions:
Writes Mark Johnson: “This uptick in bond buying has caused corporate pension funds to play a more influential role in the bond market, since pension managers tend to hold bonds for the long term. As more and more companies adopt the strategy of buying more bonds, pension demand could total $150 billion a year. It is estimated that corporate pension funds buy more than 50 percent of new long-term bonds, up from an estimated 25 percent a few years ago.”
So corporate pensions are buying more and more bonds. Which bonds? Specifically, corporate bonds: “Pension plans… like to use corporate bonds to hedge liabilities.” Corporate bonds offer the highest yields. Of course, pensions are only allowed to own investment grade corporate debt, but if they opt for longer duration or lower rated bonds they can get a higher yield. In the previous twelve months, BBB-rated corporate bonds have yielded as high as 4.83%, certainly better than the highest yield offered by the 20-year Treasury bill in the last twelve months — 3.27%.
BBB-rated corporate debt has grown to be roughly half of all corporate debt outstanding. That’s one (small, for some companies) step above junk status.
(6) During a recession, much of this investment grade debt (Pal guesstimates 10-20%) will be downgraded. But remember: pensions cannot own junk bonds. If BBB-rated debt on their books gets downgraded, they will be forced to sell it, even at a loss. If multiple downgrades happen quickly in succession, the supply of newly labeled junk bonds will overwhelm demand from other market buyers of those debt instruments. This could lead to a fire sale scenario, in which the prices of junk bonds plunge as pensions dump huge supplies into an unsuspecting market.
(7) Not only would pensions have to accept a fraction of their cost basis for these former investment grade bonds, they would also see their primary revenue stream — tax revenue — slacken during a recession. Tax receipts, after all, are as cyclical as the business cycle. When individuals and businesses aren’t making as much money, there is less available to be taxed. This would diminish demand for corporate bonds, which would cause corporate bond yields to spike.
(8) All of this chaos in the credit markets will make it very difficult for corporations to issue debt at anything other than high rates. This will cause the costs of new debt to soar high enough for buybacks to become prohibitively expensive. Moreover, cash flows will dry up, as they do in every recession, and thus every potential source of funds to use for buybacks will disappear.
(9) If the previous points play out, the biggest net buyer of U.S. equities over the last ten years will no longer be a buyer. “The largest buyer will have left the room,” as Pal says. In fact, publicly traded corporations may actually be net issuers of shares during the next recession as they were in 2008-2009.
In the words of Jesse Colombo, “If the stock market performed as poorly as it did in 2018 with record amounts of buybacks to prop it up, just imagine how much worse it would be if buybacks were to slow down significantly or grind to a halt?”
I don’t see how the preceding chain of events playing out as described would not ultimately result in a very nasty stock market crash. Whether it’s a relatively quick crash like in 2008-2009 or a bit more drawn out like from 2001-2003 is unknown. Either way, I see the above scenario as plausible. Disturbingly so.
Since I’m an income-oriented investor, my preferred method of hedging against this possible crash scenario is to hold ample cash and ultra-short term bond funds. That way, if this scenario does play out, I will be prepared to buy assets at fire sale prices with yields higher than I might ever see again in my lifetime.
Raoul Pal’s thesis is fascinating, but it could be wrong. What I’m much more certain of is that the Fed bears the majority of the blame for the underfunding of pensions and thus for putting us into a situation in which Pal’s thesis would even be possible.