The stock market faces significant headwinds in the form of two massive bubbles: corporate debt and real estate.
The U.S. government’s unprecedented stimulus package was applauded by investors on Tuesday and the stock market soared in response. That rally will be short-lived for one simple reason: it’s not enough.
While the Fed and the U.S. government’s actions were necessary and commendable, American businesses are about to reap what they’ve sewn—and that’s a massive debt bubble on the verge of popping.
In 2020 alone, $4.1 trillion worth of corporate debt will come due—a third of that is speculative grade. Globally, corporate debt has risen to an all-time high of $13.5 trillion. 20% of the corporate bonds issued over the past year have been non-investment grade. That amounts to an unimaginably large, risky pile of debt that’s now on the verge of default.
The Fed’s limitless stimulus package did much to calm fears of a financial default, but it may not be enough to keep the debt at bay. Marty Fridson, the CIO at Lehmann, Livan, Fridson Advisors LLC, cautioned that the Fed’s efforts to keep credit markets afloat won’t fix the underlying problem—the economy.
I applaud everything the Fed is trying to do, and think they will keep credit flowing. But whatever they’re doing is not going to produce a turnaround in the economy any time soon.
He pointed to the unprecedented rise in potential defaults as reason for investors to remain cautious:
In a normal cycle you don’t go from around an average default rate, which we were at for the last 12 months, to the peak default rate in one year, usually it takes a couple years to get out there.
Fridson says the market is expecting to see a default rate of 9.38% over the next year. That figure rises to 15.75% for energy companies. In December 2019, S&P Global Ratings reported default rates of just 3.1%.
Strength in the U.S. dollar is another reason to doubt the Fed’s relief package. It’s worth noting that the Fed is doing everything it can to ease upward pressure on its currency, but many are skeptical that the dollar’s advance can be stopped.
The dollar spot index showed a meaningful dip that took it down from all-time highs, but it could be short-lived.
Viraj Patel, a foreign exchange strategist for Arkera Inc., says appetite for the dollar will likely pick up again in the weeks to come.
We are still in the eye of the storm. You’re potentially seeing more countries in Europe going into lockdown and more states in the U.S. potentially going into lockdown, you’re going to see more demand for the dollar
When that happens, the stock market will be in an even more precarious position because the Fed won’t have any tools left to ride to the rescue.
On top of that, the real estate market is also on the verge of collapse.
Just like in 2008, an economic downturn is poised to wreak havoc on lenders who won’t be repaid on time.
Last week, the Mortgage Bankers Association warned that the late mortgage payments caused by coronavirus lockdowns could trigger a meltdown among mortgage servicers.
With so many mortgage defaults expected, the Association said the demand on servicers would be upwards of $100 billion—an amount that could bankrupt the system.
At the time, the MBA asked the Fed to intervene and keep the market for mortgage backed securities afloat.
The Fed did intervene, removing its limit on buying mortgage-backed securities. It’s also planning to expand purchases of both commercial and residential mortgage-backed securities.
But that may not be enough according to Bank of America, which has recommended that the Fed work toward a specific target spread between the Treasury yield and mortgage-backed securities.
The length of time the coronavirus crisis persists is crucial in determining whether companies that guarantee mortgages like Fannie Mae and Freddie Mac can withstand the wave of defaults.
According to Mark Calabria, the director of the Federal House Finance Agency, six-to-eight weeks is the limit. If defaults and mortgage holidays extend beyond that point, they’ll need greater assistance.
At this point with Fannie and Freddie, for the delinquencies that we’re expecting to see if this is a short term event say six to eight weeks, we believe that Fannie and Freddie and the servicers are equipped financially to be able to get through this time, if this goes beyond that, then we may be having to look for public assistance from Congress, from the Fed.
Famed investor Carl Icahn says he’s betting big on the bubble bursting. He is currently shorting the commercial bond market.
Icahn says assets backing corporate office and shopping mall mortgages are in the most danger:
You have a bunch of mortgages … so the banks went out and loaned money against a lot of shopping malls, office buildings, hotels and retail. The banks sold mortgages on commercial real estate and then, when they did those mortgages, [the banks] sliced and diced them and put them in something called a ‘CMBX,’ an index.
In his view, the stock market turmoil resulting from coronavirus is far from over as a wave of defaults is coming.
Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com.
This article was edited by Sam Bourgi.
Last modified: March 25, 2020 2:19 PM UTC