Coreen T Sol
March 16, 2023Economy
The End of a Credit Cycle, Not the End of the World
We are at the end of a credit cycle, not the end of the world.
Undoubtedly, you’ve read or seen reports of dire circumstances and dramatizations about the failure of two US regional banks, trouble at Credit Suisse, and now a US private lender. You may wonder how this happened, why, and what will happen next.
Central banks, including the Bank of Canada and the US Federal Reserve Board, manage interest rates and the cost of borrowing/investing to spur the economy or rein it to control inflation and economic growth. For a long time, central banks have held interest rates artificially low worldwide. Over time, people and companies became comfortable that rates would remain low, accommodating excessive borrowing in some cases. On top of that, governments supplied financial support during the pandemic to help people and businesses survive. Unfortunately, this continued to mask those people and companies who were already over-leveraged.
Queens University published an insightful article in December 2022 that tracks the rise of zombie companies worldwide. These are the companies that can only afford minimal interest payments. They typically cannot reduce their debt or increase earnings—they are like the walking dead businesses of the world. The number of zombie companies has been rising dramatically because the low-interest rates and the financial support doled out during the pandemic have been a good place for these companies to hide. Source: https://smith.queensu.ca/insight/content/Tracking-the-Rise-of-Zombie-Companies.php
They typically cannot reduce their debt or increase earnings—they are like the walking dead businesses of the world.
In the last year, interest rates have risen in Canada, the US, and elsewhere. All businesses have had to increase debt payments dramatically as rates rose. This significantly increased burden has begun to crack some companies, including the recent bank failures. As interest rates rise, not only do borrowing costs rise, but if any company has been holding bonds, the price of bonds has dropped.
Credit and borrowing were easy for a long time, encouraging people and businesses to borrow excessively. This high debt level was hidden while interest rates were shallow and financial support flowed from governments. Now that interest rates have risen substantially, we will see these over-levered businesses and zombie companies get flushed out of business, bought up, or otherwise rationalized.
This is how credit cycles unwind.
What’s next? You’ll see more volatility as more stories come forward, causing speculation and fear of contagion. If 2008 and the events following the bankruptcy of US banks this past weekend are any guide, we have confidence that government agents will not allow banks to fail. Some businesses, however, will close shop, and we expect to see increased unemployment as the job market transitions.
Since this is an interest rate driven cycle, it will also impact real estate. According to Teranet-National Bank House Price index, the Canadian real estate composite has dropped an average of 11.17% since May 2022, with some areas down more than 23%. source: www.housepriceindex.ca
Since this is an interest rate driven cycle, it will also impact real estate. If you're undistressed by real estate values fluctuating more than 10% in a year, equity fluctuations of the same magnitude should be similarly manageable.
As you'll have read in my book, Unbiased Investor, people tend to be more concerned about stock and bond market volatility, yet, seemingly unbothered by real estate price volatility. There are critical reasons for this phenomenon: You don't typically check your real estate values more than once a year, and you don't plan to sell. That may be a good rule to live by for your other long-term investments.
There are critical reasons for this phenomenon: You don't look at your real estate prices more than once a year, and you don't plan to sell. That may be a good rule to live by for your other long-term investments.
Finally of note, the bond market indicates that we may be at peak interest rates. I am expecting a transition to a recessionary contraction as this credit cycle ends. Ultimately, interest rates are anticipated to drop during this process as we move forward.
Please let us know if you would like to learn more about how we are positioned through this cycle and where we see opportunities. In addition, if your circumstances have changed in any way, please let us know that, too, so we can plan for any events you’re anticipating.
And lastly, don't forget that you make your investment decisions based on your Personal Economic Values. In 10 years from now, these events will be forgotten.