QQQ - The Coming Debt Hangover

2023-11-02 15:30:07 ET

Summary

• For nearly 15 years, corporations and especially the federal government have gorged on debt that was available at ultra-low interest rates.
• As those interest rates have risen sharply, the bill for all that debt is now starting to come due across the economy and markets.
• Why the coming debt hangover is likely to be a doozy, leading to an economic contraction in 2024 and lower entry points in the market is discussed below.

If getting drunk was how people forgot they were mortal, then hangovers were how they remembered. ”? Matt Haig.

Today, we are going to discuss the 800lb gorilla in the room that most pundits on CNBC and the rest of the financial media blithely skip over and no politician worth his salt wants to touch with a ten-foot pole. And that is the coming debt hangover after nearly 15 years of near zero interest rates. This began to be disrupted in March of last year, as the Federal Reserve embarked on the most aggressive monetary tightening course since the days of Fed Chair Paul Volcker.

The 10-Year treasury yield (US10Y) moved up 74bps in the third quarter. Earlier this month, the yield touched the five percent mark for the first time since the summer of 2007. The ratio of U.S. debt compared to GDP as already hit levels only seen during WWII previously. Interest paid on U.S. government debt in its fiscal year that closed in September was $659 billion, double what it was just two years ago. Just over half of the country's now nearly $34 trillion of debt needs to be refinanced over the next three years. At the end of the third quarter, the weighted average interest rate on that debt was just over 2.9%. This will shoot much higher in the years ahead and the Congressional Budget Office has modeled that interest paid on U.S. federal debt will hit $1.4 Trillion in FY2033.

The coming debt hangover from overleverage made possible by years and years of zero and low interest rate environments will come in three components:

U.S. Government Debt:

Longer term, the economy, the nation, and ultimately the markets have no bigger existential threat than the explosion of federal debt since the Great Financial Crisis. National debt has moved from just under $9 trillion in 2007 to nearly $34 trillion and debt growth has been accelerating.

In the federal government's FY2023 which ended in September, the U.S. ran up a deficit of $1.7 trillion during a time of economic expansion. This is 23% or $320 billion above the FY2022 deficit and would have been some $300 billion worse if not for accounting gimmicks around student loan repayments.

Noted billionaire and hedge fund manager Stanley Druckenmiller recently took Treasury Secretary Janet Yellen to the woodshed for not refinancing most of the U.S. federal debt with long-dated bonds when she had ample opportunity to do so in 2021 and the first half of 2022 when rates were much, much lower. He called her complacency the " biggest blunder in treasury history ." I can't say I disagree.

Corporate Debt:

Unlike the U.S. Treasury, CFOs at most large and midsized enterprises in the United States made good use of low interest rates to extend their debt maturities to largely far out on the horizon.

As can be seen above, a large amount of corporate debt will still need to be refinanced in the years ahead at significantly higher rates. The good news is corporate balance sheets are largely in good shape so while this will likely impact delinquency rates on the margin, they should be manageable. However, higher interest costs on debt are likely to crimp margins and earnings. One of many reasons I believe earnings estimates for S&P 500 (SP500) are too high for FY2024.

Commercial Real Estate [CRE] Debt:

This is most likely what becomes the biggest short-term issue for the market as far as debt goes. I have been warning since this spring, how quickly things are going south in the CRE credit markets. The explosion of the virtual workforce since the pandemic, the reluctance of white-collar workers to want to return to the office, and spikes in crime and homelessness rates have produced record vacancy rates for office buildings in many major cities like San Francisco, Chicago, New York City, Baltimore and Los Angeles. This has caused valuations around these properties to crash in recent years. This will become more problematic in coming years as large amounts of debt maturities come due and have to be refinanced at much higher rates.

But it is not only office properties seeing big rises in delinquency rates. Industrial and Multifamily loans are also seeing delinquency rates spiked up over the past year, and while retail delinquencies have stabilized, they remain well above six percent.

Trepp's CredIQ just finished analyzing 480 appraisals done by lenders on large commercial buildings so far in 2023. The average fall in appraisal value (typically done 4-6 years ago) was found to be 41.6%. Obviously, this means equity in a lot of commercial projects have been completely wiped out. This will complicate debt restructurings in the years ahead and will likely lead to what used to be called 'jingle mail' in the residential real estate market during the Great Financial Crisis which spawn a huge number of foreclosures and write offs.

The pending bankruptcy of WeWork Inc. ( WE ) is another negative given it has over six million square feet of office space in New York City alone. This is another headache for big Manhattan landlords like Vornado Realty Trust ( VNO ) and SL Green Realty Corp. ( SLG ) that they simply do not need right now.

Fast rising defaults will significantly impact the regional banking system, which originates some 70% of all CRE loans and holds approximately 30% of the loan balances. We have already seen the second, third and fourth largest bank failures in U.S. history headlined by Signature Bank in the first half of this year.

More regional bank insolvencies are likely to follow in 2024 and is the key reason I have had long dated, originally out of the money bear put spreads against the SPDR® S&P Regional Banking ETF ( KRE ) since early this summer. That has been a good bet and there is likely more downside on the way.

The continued deterioration in the CRE space is likely to be a key factor in the recession I see ahead in 2024 and just one part of the huge debt hangover I see on the horizon for investors. An economic contraction is not a scenario currently priced into the markets and why I continue to have 50% of my portfolio allocated to short-term treasuries yielding 5.5% in anticipation of lower entry points in the quarters ahead.

People who think a tax boost will cure inflation are the same ones who believe another drink will cure a hangover. " - Ronald Reagan.

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