My 2016 Debt Report – Plus, The One Kind of Debt You Should Buy

Warren Buffett told people last weekend at the Berkshire Hathaway annual meeting that America doesn’t need to be great again because it is already great.

He is 100% wrong. Maybe someone has been spiking Mr. Buffett’s cherry cokes!

Such empty platitudes are exactly the type of nonsense that will lead us over the cliff unless our political and business leaders wake up and stop borrowing us into oblivion.

Underneath the bullish blather of the past several months, bearish fundamentals haven’t changed at all. We are crushed by unsustainable debt on all fronts – corporate, national and global – and the dimensions of this crisis are so overwhelming that Wall Street and the mainstream financial press ignore or dismiss it because it contradicts the phony stability narrative they desperately try to promote. Those who ignore what is going on do so at their own peril. The world is literally borrowing itself to death.

And believe me – Mr. Buffett knows the truth.

Today, I want to give you a comprehensive picture of the debt bubble the world is in – and show you exactly how deep we’re buried, and how far we’re going to have to dig to get out.

Brace yourself: This rabbit hole is deep.

“But I do see a few ways to make money despite the coming storm.

The “Ostrich Approach” Ignores Real Global and National Debt Figures

Sadly, even the most sophisticated among us are sticking their heads in the sand right now. In addition to the Oracle of Omaha’s Happy Talk, other well-known investors with a vested interest in keeping the global Ponzi game going are pretending that the world can keep borrowing itself into oblivion. For example, recently the highly respected Ron Baron, Chief Executive of Baron Capital, indicated that he doesn’t want to recognize that we have been living in a historically aberrant period for the last three decades (particularly since the financial crisis) and that debt poses a direct threat to financial and geopolitical stability. Mr. Baron’s comments in a recent Barron’s interview were typical of the type of complacency that enables political and business leaders to pursue short-term oriented policies that are seriously damaging our long-term economic prospects:

“I happen to think we are on the verge of much faster growth than most people think. When people talked about debt relative to the size of the economy my eyes used to glaze over. But what is it now, 330% of GDP [including household, corporate, financial, state, and local debt]. It was 150% when I started Baron Capital [in 1982], and in the 1930s, it was 150%; the only time it was around 300% was 1929. But we’ve learned to avoid that by making our currency worth less – the story with quantitative easing. That’s inflation. Everyone tried to predict what will happen to rates and oil, and what the Fed and Putin and Donald Trump will do, or whether Ted Cruz will abolish the Fed. But sooner or later, our citizens vote to make the economy stable. Everything will work out over the long term.”

Of course, there is absolutely no reason in the world to believe that growth is going to accelerate in view of the growing debt burdens facing the US economy and the total lack of any policy initiatives to stimulate growth. In fact, there is every indication that the government is doing everything it can to slow growth by piling on higher taxes and more regulation.

But what is even more disturbing about these remarks is that Mr. Baron acknowledges the enormous accumulation of U.S. debt and the inflationary consequences of QE but simply waves the problem away and argues that the American people will vote for the right leaders who will fix things. Maybe Mr. Baron is watching another election because none of the candidates running for president in the US have put forth a credible plan to deal with America’s economic problems. Everyone loves an optimist, but cock-eyed optimism isn’t going to save us this time. Mr. Baron is famous for his optimism (later in the interview he makes his case for why Tesla Motors, Ltd. (TSLA) should trade at three to four times its current already ridiculous valuation in five years, a view I believe is not merely optimistic but delusional). But concluding that “[e]verything will work out over the long term” flies in the face of history and common sense.

Nothing is being done to rein in the debt that is suffocating economic growth. When some of the smartest guys in the room think what is happening is acceptable, their attitude goes a long way to explaining why the problem is unlikely to be fixed.

In order to give you an accurate picture of what’s going on, I’d like to enlist the help of some smart people whose analysis I actually admire.

Hoisington Investment Management Company is a thought leader in the investment world. In addition to running one of the world’s best performing bond funds, the firm’s principals, Van Hoisington and Lacy Hunt, always tell the unvarnished truth about the debt bubble that started before the 2008 financial crisis and expanded to unthinkable dimensions since then. In the firm’s most recent “Quarterly Review and Outlook,” they describe how debt is growing exponentially faster than the economy in the U.S. In 2015, nominal GDP rose by $549 billion while U.S. nonfinancial debt grew 3.5 times faster by $1.912 trillion. The chart below illustrates how debt grew much faster than the underlying economy since the early 1980s. The gap between the two accelerated since the late 1990s.Figure-1-IIAccording to Hoisington and Hunt, the ratio of nonfinancial debt-to-GDP rose to 248.6% at the end of 2015, higher than the previous record of 245.5% set in 2009 and well above the average of 167.5% since this figure started to be tracked in 1952. They also point out that since 2000 it has taken $3.30 of debt to generate $1.00 of GDP compared with $1.70 in the 45 years prior to 2000. This points to the fact that a greater proportion of new debt is devoted to unproductive uses (more on this below).

Debt drains away vital resources from economic growth. Fighting a debt crisis with more debt is doomed to failure, yet that is not only what global central banks did during the crisis but long after markets stabilized (though the crisis never truly ended, just slowed). This was an epic policy failure that continues today.

U.S. government debt is growing to unsustainable levels. Gross debt (excluding off-balance sheet items) reached $18.9 trillion at the end of 2015, equal to 104% of GDP (considerably higher than the 63-year average of 55.2%). Government debt increased by $780.7 billion in 2015, or $230 billion more than the nominal or dollar rise in GDP. This actual debt increase is considerably larger than the budget deficit of $478 billion reported by the government because many spending items were shifted off-budget. Readers should remember this the next time The Wall Street Journal editorial page trumpets that the deficit dropped significantly from the four consecutive years of $1 trillion+ deficits between 2009 and 2012. And these figures don’t even touch upon the $60 trillion of unfunded liabilities (calculated on a net present value basis) for Social Security and other entitlement programs.

The Congressional Budget Office (CBO) projects that federal debt will rise to $30 trillion by 2027 without assuming any type of recession or crisis that would increase that figure.  I believe there is at least a 75% chance of another financial crisis in the next decade; if I am correct, the CBO’s figure is conservative. And the odds of a recession during that period are 100%. On the state and local level, an increasing number of states and cities are facing debt crises. Furthermore, because any recession or crisis will occur within the context of a much more leveraged world than the last crisis and recession, it is likely to be far more severe. Government finances are broken and politicians are doing nothing to fix them; in fact, they are not even discussing the subject in a serious manner.

Globally, the debt picture is more disturbing. Total public and private debt/GDP is 350% in China, 370% in the U.S., 457% in Europe and 615% in Japan, respectively. Those numbers should speak for themselves.

Corporate Debt Isn’t Just Unproductive – It’s Deadly

If debt were used for productive purposes, there would be light at the end of the tunnel. Unfortunately, however, it is not, leaving a black hole beyond that could swallow the economy and markets. The vast majority of debt is used for unproductive purposes including massive stock buybacks, leveraged buyouts, debt-financed M&A, consumption, housing and financial speculation. The fact that individuals at the top (the so-called 1%) profit enormously from unproductive activities is a fatal flaw in our economic arrangements.

As Hoisington points out, in 2015 business debt increased by $793 billion while total gross private domestic investment (which includes fixed and inventory investment) rose by a mere $93 billion. This means that the other $700 billion was used for the unproductive activities listed above. At the same time, corporate cash flow declined by $224 billion and corporate profits fell by 15% to $242.8 billion, their lowest level since 1Q11 (another set of facts that is ignored by Wall Street and the mainstream financial media). Debt spent on unproductive activities does not create the income necessary to service and ultimately repay that debt. It does not create jobs, build plants or fund research and development. Nor does it increase the productive capacity of the economy or promote economic growth. It simply sucks financial and intellectual capital away from productive uses.

Capital spending plans in early 2016 are being reduced. Corporate America is borrowing itself into oblivion. The early signs of that crisis are starting to appear as several large companies filed for bankruptcy in April including Peabody Energy Corp. (BTU), SuneEdison, Inc. (SUNE) and Energy XXI Ltd. (EXXI). Other large borrowers likely to file soon include Sandridge Energy Inc. (SD) and Linn Energy, LLC (LINE). Billions of dollars of debt is being wiped out in these business failures, all of which were caused by excessive borrowing and excessive optimism. Nobody likes pessimists, but perhaps they should be acknowledged as realists and paid more heed.

Low interest rates enable corporations to borrow money for unproductive activities such as overvalued M&A transactions (see under: Valeant Pharmaceuticals, the entire pharmaceutical industry) and excessive stock buybacks at elevated stock prices. Idiotic tax policies further encourage corporations that can’t grow organically and/or want to reduce their taxes to enter mergers that primarily benefit short-term oriented shareholders and executives while leading to large layoffs and lower capex and R&D spending. Corporate spending on unproductive activities far exceeds the free cash flow companies are generating, leading them to inflate their balance sheets with more debt. As Societe Generale strategist Andrew Lapthorne points out: “The reality is US corporates appear to be spending way too much (over 35% more than their operating cash flow, the biggest deficit in over 20 years of data) and are using debt issuance to make up the difference.”

This excessive spending exceeds previous peaks in 1998 and 2008 (both of which ended in deep corporate credit crises). And for those who argue that the problem is limited to energy companies, think again: even if we exclude the oil and gas sector, corporations are still outspending free cash flow by a large margin.

Fig-2-IIAs Mr. Lapthorne argues: “No matter where you look or how you measure it, leverage is elevated and continues to rise to unusually high levels given where we are in the cycle [late], with the most worrying rise in small cap stocks’ debt levels [which coincides with junk-rated companies]…The catalyst for a balance sheet crisis is rarely the affordability of interest rates, so a 25bp rise in Fed rates is neither here nor there. Credit market risk is about assessing the likelihood of getting your money back. As such asset prices (i.e. equity markets) and asset price risk (i.e. equity volatility) are far bigger concerns. So all you need for a balance sheet crisis is declining equity markets, a phenomenon the Fed appears desperate to avoid.” Pointing to Figure 3 below, Mr. Lapthorne illustrates one of the reasons the Fed is so reluctant to raise rates at all: the Fed’s shadow third mandate of propping up stock prices.

This epic corporate borrowing binge is facilitated by a toxic combination of bad policies. When you combine years of unduly low interest rates with excessively generous executive compensation schemes geared to share prices, the short-term demands of investors who never ran businesses themselves (and who are endlessly celebrated by the financial press), and a flawed tax system, you have a toxic brew. As Mr. Lapthorne points out, corporations are “effectively mortgaging future growth to compensate for the lack of demand today.” That lack of demand is the result of a total lack of pro-growth fiscal policies coupled with an expanding government whose regulatory overreach is suffocating free enterprise. The damage is going to be greatest among the lowest rated companies that carry high debt loads and small equity market caps. This is one reason why Marty Fridson’s forecast of $1.6 trillion of corporate defaults in the 2016-19 period is so credible.


A decade ago, private equity firms engaged in an orgy of mega-buyouts that generated negative nominal and real returns. Several of these deals – Caesars Entertainment, TXU – ended up in spectacular bankruptcies that wiped out billions of dollars of investors’ capital. (You can read my analysis of the CZR debacle here, and get my recommendation.)  While few large LBOs are being done today, Corporate America picked up the mantle of borrowing from the private equity industry. Goldman Sachs confirms Mr. Lapthorne’s work and goes farther in describing the corruption of corporate balance sheets by pointing out that U.S. corporations accumulated roughly $1 trillion of goodwill during the post-crisis M&A explosion. Coupled with more than $2 trillion of stock buybacks since the crisis, Corporate America spent virtually all of its profits and free cash flow on cannibalistic activities rather than investing in new capital projects, research and development and other productive activities. It now sits on a ticking time bomb of debt that it cannot repay even if interest rates stay suppressed for years to come.

The epic collapses of SunEdison, Inc. (SUNE) and Valeant Pharmaceuticals (VRX), two companies that relied on heavy borrowing and expensive acquisitions to inflate their stock prices and attract hedge funds to their stocks, illustrates the dangers of this approach. I expect VRX to start taking significant goodwill write-downs on the companies for which it overpaid (i.e. Sprout Pharmaceuticals). But that is only the beginning. We can expect to see huge goodwill write-offs across the corporate world over the next few years as companies purchased during a bull market turn out to be worth far less than expected (by their overpaid investment bankers, accountants and attorneys, not by me).

Mr. Lapthorne correctly points out that markets are ignoring this risk. The Office of Financial Research (OFR), an independent group within the U.S. Treasury whose remit is to monitor financial stability, warned in its 2015 annual report that the build-up of non-financial corporate debt is a major systemic risk:

In our assessment, credit risk in the U.S. nonfinancial business sector is elevated and rising…The evidence is broad. Credit growth to the sector has been rapid for years, pushing the ratio of nonfinancial business debt to GDP to historically high levels. Creditor protections remain weak in debt contracts below investment grade. These factors are consistent with the late stage of the credit cycle, which typically precedes a rise in default rates.”

Apparently not everyone working for the government is clueless. This warning joins earlier warnings from the Geneva-based International Centre for Monetary and Banking Studies (2014) and The McKinsey Global Institute (2014) pointing to the dangerous accumulation of global debt. The question that must be asked is why the Federal Reserve remains oblivious to the consequences of its failed policies. After all, it’s not as though years of zero interest rates and trillions of dollars of quantitative easing led to economic growth; quite obviously they did the opposite. Ben Bernanke wanted to encourage risk-taking by lowering interest rates, but being a professor with no real-world experience failed to understand the difference between risk-taking and speculation. Risk-taking involves engaging in activities that lead to substantive economic gains through the expansion of the productive capacity of the economy. Speculation involves the devotion of capital to unproductive activities based on the expectation that asset prices will either remain inflated or the owners of assets will be able to sell them to the next fool before the ceiling falls in.

As Mr. Lapthorne writes, all corporations are doing is “remortgaging shareholder equity in an attempt to boost short-term share price performance.” Corporate America is engaging in an orgy of speculation facilitated by cheap money, bad tax policy, flawed executive compensation schemes and a lack of pro-growth fiscal policies. They are cheered on in this activity by activist investors who are in turn praised by an uneducated and poisonous financial press. The consequences of this are as clear as the nose on your face. Investors don’t want to be riding this train when it runs off the rails.

One Good Bet In A World of Risky Debt

Gullible investors, cheered on by clueless or conflicted Wall Street firms, are rushing back into risky debt at precisely the worst possible time. Emerging markets are being buoyed by recent easing moves in India, Turkey, Hungary, Taiwan (all of which cut interest rates) and Singapore (which uses exchange rates rather than interest rates to guide monetary policy). But emerging markets remain vulnerable to any rise in the U.S. dollar and general global economic weakness. Investors are also pouring money back into the high yield bond market on the mistaken belief that the worst is over for leveraged corporate borrowers. As outlined above, this is a poor assumption. The corporate default rate is just starting to spike and hundreds of billions of dollars of defaults will pile up over the next few years. Investing on a broad basis in the high yield market through ETFs and/or mutual funds will prove to be a mistake. There are opportunities in specific bonds as investors throw babies out with the bathwater, but the overall market remains overpriced and unattractive. (You can read my new report on the six people who destroyed bonds as an investment class here.)

Investment grade, Treasuries and other high rated bonds remain a poor bet even if interest rates drop further as they are likely to do as the economy remains weak. The largest bond funds continue to disappoint as zero rates in the U.S. and negative rates abroad render it nearly impossible for traditional managers of high quality debt to generate decent returns. Recently Bill Gross was lauded by Barron’s for finally producing a +2% 1Q16 performance after years of poor performance at PIMCO and the Janus Funds. Before that, since taking control of his Janus fund on October 6, 2014, he had produced a puny return of 1.8%, which comes to approximately 10 basis points a month. This may be better than the performance of his old fund, PIMCO’s Total Return Fund that lost 1.64% over the same period, but it is still unimpressive. Furthermore, his 1Q16 return was earned by using a significant amount of leverage and derivatives, meaning it is much less impressive on a risk-adjusted basis. In the kingdom of the blind, the one-eyed man is king. Unfortunately, in bond-land there are few kings left standing (Jeff Gundlach being one of the few). Investors will have to look elsewhere for a decent return on their capital.

However, I think that the fallen angel space (fallen angels are bonds that lose their investment grade ratings) looks attractive. On a risk-adjusted basis, fallen angel bonds tend to produce very attractive returns. They rarely default (except in cases of fraud or extreme changes in conditions like the current commodity collapse) and tend to be large companies with significant resources to ride out storms. Investors looking for yield should seriously consider the fallen angel space.

A simple way to play fallen angels is to buy the MV Fallen Angel ETF (NYSEARCA: ANGL).


Michael Lewitt

13 Responses to “My 2016 Debt Report – Plus, The One Kind of Debt You Should Buy”

  1. Looking at figure 1, we can expect a nasty bout of stagflation; inflation with low or no economic growth. I think it already started even if the official inflation figures try to deny it. This week end I went to my local food market in Southern CA and wanted to buy a bar of Hersey chocolate. The price was $ 2.50 vs. $ 2 the week before. A 25% increase. Stagflation will be devastating to workers, who will not see their salary rise, and savers because corporations’ result will be bad. ANGL is a good idea, thanks.

  2. I think that, even if over extended, Cali munis are safe for the moment. California is part of the core. When fringe markets crash, people move back to the core. I’m long Cali munis through Pimco CEFs.

  3. The debt situation has become so extreme nobody can make an intelligent guess as to which instruments will turn out to be safe. The near-zero interest rate policy is the key. The Fed Funds Rate should be renamed the Fed Fear Rate. It tells you how afraid they are about their house-of-cards credit bubble collapsing. They don’t dare to raise rates at this point; and that speaks volumes. And the same goes for Europe and Japan. The 3 biggest banking communities of the world are living in fear.

  4. Barry Dunkley

    I am struggling with the OVERALL ORGANIZATION of the Money Map Organization and its stable of “Consultants” and their multitude of “Predictions”???
    I find it disturbing that you refer to the epic collapse of SUNE, and yet just a few short months ago YOUR SUPPOSED COLLEAGUE… Dr. Kent Moores was touting the virtues of this company and how he thought it would prove to be an outstanding investment??? It appears by your comments, that YOU did NOT AGREE???
    So, I guess my attitude towards the entire group, is that we have a large number of people in this organization that are, in actual fact, IN COMPETITION WITH EACH OTHER for clients and to bring more $$$ into the fold for the “Organization” with little internal consultation and certainly overall consensus agreement.
    In other words, I have TOTALLY LOST CONFIDENCE in this organization as a whole and refuse to “throw good money after bad”…
    Overall, a sad commentary!!!

  5. This was an excellent article. Way above average in the things we call news.
    Only one thing i have to quibble about and that is how you incorporated speculation into this piece and gave it a bad connotation. Along with it being a short term bet on prices, it adds liquidity and price discovery to markets. And both of those are sorely needed for well functioning markets.
    What corporate america is doing is not speculation. It is more akin to a pump and dump.

  6. As far as owning debt right now, I own a closed-en muni debt fund that has performed well over the past 6 months. I wonder how it will do if the economy collapses or if the debt collapses.
    In addition, my brief research shows that this fallen angel fund is similar to a high-yield junk bond fund. If I am correct, why would we invest in a high yield junk bond fund. If I am incorrect, please point out the differences.

  7. An Empire that places top priority on the amount of power and wealth one can accumulate before they die is no Empire of mine. But it’s nice to have enough money for the basics – food, shelter and health needs. So figuring out it’s a rigged game and spending some time learning the rules does give one the tools to use the market to their benefit – instead of allowing Wall Street to benefit off of their ignorance.

  8. […] Large bond funds like PIMCO and Vanguard are turning in real (i.e. inflation-adjusted) returns of zero, making them nothing more than glorified money market funds (with little glory). However, they are considerable more dangerous than money market funds because of their high exposure to derivatives and use of leverage. Investors should minimize bond exposure as much as possible. I do see one good opportunity in the fallen angel space, which you can read about here. […]

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