With the Nasdaq now trading at all-time highs and the S&P and Dow Jones Industrial Average nearly regaining their pre-coronavirus highs, many are asking why the Federal Reserve continues the rollout of new programs intended to help the markets recover. One of those asking the question is Ed Yardeni, founder of Yardeni Research.
The Fed announced last week that it would begin buying individual corporate bonds. With this, Yardeni is asking if enough is enough.
“The Fed’s shock-and-awe campaign worked amazingly well,” Yardeni said yesterday in his daily market note. “This raises the question of whether the Fed really needs to do much more.”
The fear, well-founded and too-often ignored, is that the Fed is creating another bubble. It can create this by doing anything it can to boost the stock market.
“The goal was to restore liquidity to the credit markets,” Yardeni said. “They are clearly functioning well again. If the Fed persists in flooding the markets with liquidity, the risk is that the Fed will create the greatest financial bubble of all times.”
If companies know that the Fed will step in and buy their bonds in a pinch, there’s little downside risk. Interest rates are virtually zero, so borrowing costs are negligible. If a new bond offering struggles due to lack of demand, the Fed will step in and become a buyer.
Citigroup says new bond issuance this year has topped $1 trillion. This will likely double last year’s totals according to Citigroup.
To be fair, the Fed has only purchased around $7 billion in bonds in a $6.7 trillion market. Therefore, the number of purchases thus far have been completely inconsequential. And the plan will expire in September, so it won’t be in effect for very long.
Still, companies adding debt during a time of economic crisis could lead to bad outcomes in the future.
Adam Slater, lead economist at Oxford Economics, wrote, “In part, the rise in corporate debt is a healthy development as it represents firms drawing on credit lines, government loan schemes, and other sources to get through a cash flow deficit resulting from lockdowns and social distancing. But as we have previously warned, the rise in debt could bring considerable risks, especially if economic recovery proves slow and patchy.”
In a worst-case scenario, a company that doesn’t bring in enough revenue to cover its debt payments becomes a “zombie” company.
Since the pandemic started, the number of zombie companies has doubled. Zombie companies are those with earnings before interest. They also have taxes divided by their interest expenses of below 1 (or their “interest coverage ratio”). Now, the number of these companies stands at 32%.
That’s an astounding number of companies that simply can’t pay their interest payments, and aren’t a viable business.
To see the inflated bubble, look no further than the major stock indexes. Our country is facing a pandemic unlike anything any of us have lived through, there’s no vaccine, nearly 40 million Americans are without a job, and the S&P 500 is trading at 21.9 times expected earnings over the next 12 months.
According to FactSet, that’s the highest reading in the last 18 years. It’s also closing in on the record reading of 24.4 on March 24, 2000. This happened around the time the dotcom bubble was set to implode.
The Fed will continue to buy up all the corporate bonds it can as long as interests stay low. These include those that fell into “junk” status in late March, and the zombies will walk amongst us.
Yardeni says he doesn’t understand why the Fed is buying such “dodgy” bonds. With these programs, he says “The Fed is stoking moral hazard.”