Famous Economist Mohamed El-Erian Warns Investors To Stay Away From Zombie Companies And Zombie Markets
It’s time for investors to stop buying stocks that are ‘stunningly decoupled’ from reality, economist warns. Famous Economist Mohamed El-Erian Warns Investors To Stay Away From Zombie Companies And Zombie Markets
‘The investing challenge may well shift in the months ahead from riding an exceptional wave of liquidity, which lifted virtually all asset prices, to steering through a general correction in prices and complex individual nonpayments.’
That’s Mohamed El-Erian, Allianz’s chief economic adviser, talking about what investors should expect going forward, as “the financial stress caused by COVID-19 is far from over.”
El-Erian, the former Pimco CEO, pointed to several “worrying signs,” including a record-breaking pace for corporate bankruptcies, job losses moving from small and medium-size firms to larger ones, and more households falling behind on rents, to name a few.
“Investors are showing insufficient concern. Some continue to expect a sharp, V-shaped recovery in which a vaccine, or a buildup of immunity in the population, allows for a quick resumption of normal economic activity,” he wrote in the Financial Times. “Others are relying on more backstops from governments, central banks and international organisations.”
He explained in the op-ed that investors still have time to prepare for the tough times ahead and follow the lead of Wall Street pros by adjusting their portfolios accordingly.
“Rather than buying assets at valuations stunningly decoupled from underlying corporate and economic fundamentals, investors should think a lot more about the recovery value of their assets,” he said, pointing to a “new generation” of traders pushing stocks relentlessly higher. “The sense that the worst did not come to pass has fed complacency among investors of all stripes.”
While retail investors continue with the risk-on attitude, El-Erian says the smart money has been raising cash in hopes of putting a “dual investment strategy” to work — this includes keeping some powder dry for rock-solid companies to correct to bargain prices as well as being ready to step up with “well-structured rescue financing” when bankrupt companies look to reorganize and recover.
“Liquidity-driven rallies are deceptively attractive and tend to result in excessive risk-taking. This time, retail investors are front and centre,” he wrote, adding that the market’s “next stage” will require “much more careful scrutiny from investors than the past few months have demanded.”
America’s Zombie Companies Have Racked Up $1.4 Trillion of Debt
They were once America’s corporate titans. Beloved household names. Case studies in success.
But now, they’re increasingly looking like something else — zombies. And their numbers are swelling.
From Boeing Co., Carnival Corp. and Delta Air Lines Inc. to Exxon Mobil Corp. and Macy’s Inc., many of the nation’s most iconic companies aren’t earning enough to cover their interest expenses (a key criterion, as most market experts define it, for zombie status).
Almost 200 corporations have joined the ranks of so-called zombie firms since the onset of the pandemic, according to a Bloomberg analysis of financial data from 3,000 of the country’s largest publicly-traded companies. In fact, zombies now account for nearly 20% of those firms.
Even more stark, they’ve added almost $1 trillion of debt to their balance sheets in the span, bringing total obligations to $1.36 trillion. That’s more than double the roughly $500 billion zombie companies owed at the peak of the financial crisis.
The consequences for America’s economic recovery are profound. The Federal Reserve’s effort to stave off a rash of bankruptcies by purchasing corporate bonds might very well have prevented another depression.
But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come, according to economists.
“We have come to the point that we should ask, ‘what are the unintended consequences?’” said Torsten Slok, chief economist at Apollo Global Management Inc. “The Fed, for stability reasons, decided to step in. They knew they were going to create zombies. Now the question becomes, ‘what about the companies that have been kept alive that otherwise would have gone out of business?”’
Zombie Firms Are Sitting On An Unprecedented $1.4 Trillion Of Obligations
While zombie firms are more commonly associated with 1990s Japan, post-crisis Europe or even China in recent years, their ranks in the U.S. have been increasing for over a decade, fueled in part by years of ultra-loose monetary policy.
Zombie companies get their nickname because of their tendency to limp along, unable to earn enough to dig out from under their obligations, but still with sufficient access to credit to roll over their debts. They’re a drag on the economy because they keep assets tied up in companies that can’t afford to invest and build their businesses.
Of course, not every company that becomes a zombie is destined to stay one forever. There are plenty of comeback stories, from Boston Scientific Corp. to Sprint Corp. Many firms that have seen earnings wiped out due to the coronavirus outbreak are likely to rebound once a vaccine allows the global economy to return to a more normal footing, and may ultimately not need all the debt they raised.
Yet the sheer amount of borrowing undertaken by struggling corporations in recent months will almost certainly limit the capacity of some to make capital expenditures and adapt to shifting consumer habits as Covid-19 alters how Americans spend their money.
Bloomberg’s analysis looked at the trailing 12-month operating income of firms in the Russell 3000 index relative to their interest expenses over the same period.
The results paint a grim picture. More than a sixth of the index, or 527 companies, haven’t earned enough to meet their interest payments. That compares with 335 firms at the end of last year. The $1.36 trillion they collectively now owe dwarfs the $378 billion of debt zombie firms reported before the pandemic laid waste to balance sheets.
Boeing has seen its total obligations balloon by more than $32 billion this year, while Carnival’s debt burden has increased $14.8 billion, Delta has added $24.2 billion, Exxon $16.2 billion and Macy’s $1.2 billion, according to data compiled by Bloomberg.
What Bloomberg Intelligence Says:
“Zombie firms have been building due to lax markets that provided staying power for seemingly insolvent companies. The pandemic exacerbated this perennial issue. From an economic theory standpoint, zombies lower long-term growth as you have mis-allocation of capital and companies commanding market share but without the ability to invest in growth. Nearer term, because zombie firms exhaust value, credit-recovery assumptions should go lower, which arguably should send spreads higher to compensate.”
— Noel Hebert, Director of Credit Research
A spokesperson for Boeing directed Bloomberg to the company’s third quarter earnings call, in which Chief Financial Officer Greg Smith said that managing liquidity and balance-sheet leverage are top priorities, and reducing debt will be a key focus once cash generation returns to more normal levels.
Representatives From Carnival And Delta Declined To Comment
Exxon referred Bloomberg to comments last month from senior vice president Andy Swiger during the company’s earnings call in which he highlighted the oil producer’s efforts to reduce operating expenses and increase divestments while keeping gross debt levels stable.
A spokesperson for Macy’s said that the company is confident in its financial position, and expects to have sufficient liquidity to fund operations and retire debt maturities due in the coming years.
Among new entrants, all four major U.S. airlines, with a combined $128 billion of debt, have become zombies in 2020. And movie theaters and other entertainment companies on the list grew from 2 last year to 10, accounting for nearly $28 billion of additional debt.
“We distinguish between the walking wounded and the walking dead,” said Ken Monaghan, a portfolio manager at Amundi Pioneer, which oversees about $85 billion. “The question is whether the business model has changed so significantly as a result of the pandemic that survival comes into question. Few sectors are likely to die, but some may require a radical transformation to survive and attract capital.”
Economists have long warned that zombies are less productive, spend less on physical and intangible capital and grow less in terms of employment and assets than their peers.
But new research from the Bank for International Settlements shows that zombies may be even more damaging to an economy than previously thought.
Not only are firms staying in a zombie state for longer than in years past, but of the roughly 60% of firms that do manage to ultimately exit zombie status, many nonetheless experience prolonged weakness in productivity, profitability and growth, leading to long-term underperformance.
Moreover, recovered firms are three-times more likely to become zombies again compared to firms that have never been one, according to the September study, which examined companies in 14 advanced economies over three decades.
“The zombie disease seems to cause long-term damage also on those that recover from it,” the BIS’s Ryan Banerjee and Boris Hofmann wrote in the report. Therefore, “a firm’s viability should be an important criterion for its eligibility for government and central bank support.”
A representative for the Fed declined to comment.
Some say the concern over the spread of zombie companies is being over-hyped.
While they accounted for 41% of U.S. firms in a UBS Group AG analysis based on their interest-coverage ratios as of the second quarter, weighted by assets the percentage declined dramatically, to just 10%. And when using the bank’s preferred methodology, which looks at debt to enterprise value, the share fell to just 6%, close to average levels since the late 1990s.
“The zombie problem is fairly benign in the U.S.,” said Matthew Mish, a strategist at UBS. “I don’t think the problem looks any worse than the last two recessions.”
Others aren’t so sure.
“The zombie question is one of the great open issues regarding the legacy of the pandemic,” said Nathan Sheets, chief economist at PGIM Fixed Income. “Will our economy coming out of the pandemic be as dynamic and flexible as before? I’m cautiously optimistic because competition is deeply embedded in the U.S. system.”
Still, corporate deleveraging in the years ahead will result in slower growth, subdued inflation and low rates “for as long as the eye can see,” he added.
America’s Economy Faces A Zombie Recovery, Even With Vaccine
Businesses in the area where Night of the Living Dead was filmed are staggering along on government stimulus but may collapse before more help arrives.
This was supposed to have been a good year for zombies. At least that’s what Kevin Kriess, owner of the Living Dead Museum and Gift Shop in Evans City, Pa., thought. The business, not far from the cemetery where George Romero filmed the 1968 zombie classic Night of the Living Dead, was gearing up for an expansion.
Kriess planned to open a second location at a mall a 45-minute drive away, where the sequel Dawn of the Dead was set. “This year was going to be super big for us,” says Kriess, a horror-movie buff turned purveyor of T-shirts, posters, and other memorabilia to obsessed fans of the undead.
Instead, in October, Kriess packed up his ghoulish wares and turned off the lights for the last time in the storefront he had rented across from a funeral home, another victim of a pandemic that has upended lives around the world.
With 300,000 dead and millions displaced from their jobs, what Kriess is going through hardly registers on the economic damage scale. But his story is representative of the broader experience at the end of a calamitous year.
Much of the economy remains in suspended animation—a zombie recovery—that masks how much the crisis has curtailed ambitions and how much depends on a new injection of government aid that has languished for months in a partisan Congress.
Hope is on the horizon in the form of a vaccine. But an economy that seemed over the summer to be roaring back to life is facing a dark winter. In November, the U.S. created just 245,000 jobs, a pace at which it would take three and a half years to get employment back to February’s levels. Now, as cases of Covid-19 and deaths from the disease surge to record highs, states are imposing new restrictions.
The U.S. economy is likely to end the year almost 3% smaller than at the start. That’s not bad considering where things stood in the second quarter, when output collapsed at an annualized rate of more than 30%. But for Kriess and many other business owners who went into 2020 thinking they’d be riding an expansion, it feels worse. At the beginning of 2020, the U.S. economy was expected to grow by at least 2%. That means it’s closing the year roughly 5% smaller than it would have been.
As with the virus, the impact of the Covid-19 recession has been unequal. Although millions of people in the leisure and travel industries remain out of work, other Americans will emerge unaffected economically, and perhaps better off.
That pattern holds true in Butler County, which straddles the suburbs and exurbs of Pittsburgh, including Evans City. In October, the county had an unemployment rate of 5.9% compared with 6.9% nationally. But scratch the surface, and you discover all the little ways the local economy is hurting.
Down the road from the Living Dead Museum, at a restaurant painted Pittsburgh Steelers black and gold, Deb Collins has watched revenue collapse. Business at Sports & Spirits is down 60% this year, she says, making 2020 the worst since she and her husband bought the place two decades ago.
The surge in new cases has her worried that many small businesses like hers won’t make it through the winter, especially after Pennsylvania responded by again suspending indoor dining. “We’re hunkering down, just trying to stay afloat,” she says.
At Fibercon International Inc., a family-owned company in Evans City that makes bobby-pin-thick strands of steel to reinforce concrete floors and walls, orders are off by about one-third this year, according to Kevin Foley, vice president of sales and marketing. The company, which received a $162,300 federal Paycheck Protection Program loan in the spring, has managed to avoid laying off any of its 18 workers.
Its products are used in new factories and warehouses around the world, so Fibercon’s order book is a bellwether—and the signal is not good. One project for a major retailer has been put on hold, Foley says, and a client that builds industrial parks has halted new construction.
Orders are slow going into next year, and the company’s sales team isn’t traveling. “It’s a weird situation right now because our business is based on meet and greet, being out in the field,” Foley says. “And we’re landlocked.”
Butler County has seen industries rise and fall. Evans City began life as an oil town. Butler, the county seat, was once home to Pullman-Standard, which made many of the U.S.’s railroad carriages last century. The county went into the pandemic having found a healthy 21st century balance.
Cranberry Township, at the junction of two major interstates and a 20-minute drive from downtown Pittsburgh, has been one of the city’s fastest-growing suburbs for decades and built a brand as a low-tax alternative for corporate headquarters. But the county also prides itself on its manufacturing base.
That mix has helped it avoid the hit that many other communities have taken. Yet Butler County went into the closing months of 2020 with about 5,000 fewer people working than in February, a dip of 5% that took the ranks of the employed in the county down to 90,000, a level last seen in 2012.
Most of those who haven’t gotten their jobs back were in the leisure and hospitality business or in health care, says Leslie Osche, chair of the county board of commissioners. If all goes well, she says, they should be back at work within 18 months to two years.
Still, Butler County is facing longer-term questions. The fate of an AK Steel plant on the outskirts of Butler that bills itself as the only U.S. producer of electrical steel used in transformers remains uncertain. The Trump administration this year opened a national security investigation that could clear the way for new tariffs on imports of this type of steel. “We saved 1,400 jobs at AK Steel, right here in Butler,” Trump said when he campaigned in Butler a few days before the election.
In a statement at the time, Cleveland Cliffs Inc., which bought the plant as part of a merger with AK Steel this year, indicated that the Trump administration had promised all sorts of actions. But neither the White House nor the Commerce Department have made any substantive moves. The only thing the administration has announced is an agreement with Mexico for greater monitoring of exports of electrical steel. So the fate of the plant may hang on what President-elect Joe Biden’s administration chooses to do.
The same sort of uncertainty hangs over other key elements of the local economy. Will there still be demand for all the midlevel office buildings in Cranberry Township? And for the restaurants, hotels, and other services that have sprung up to cater to the people those offices attracted?
Employees have been quicker to return to work in suburban offices where they can commute by car and don’t need to take elevators, says Jeremy Kronman, vice chairman of commercial real estate firm CBRE Group Inc.’s Pittsburgh practice. But companies are also making long-term adjustments.
Westinghouse Electric Corp., whose headquarters campus accounts for about 1 million of the 4.5 million square feet of office space in Butler County, is reducing its footprint, Kronman says.
It’s a move many companies across the U.S. are considering and one of the reasons that Richard Barkham, CBRE’s chief economist, thinks the market for office space will lag the broader recovery in the U.S. in 2021. But it also sits next to other questions that are unanswerable for the time being.
Thanks to government action, many metrics of economic pain, such as bankruptcies and evictions, look better than they did before the pandemic. But economists like CBRE’s Barkham say that government help is just holding back a tide that may be unavoidable in the end—too many companies can’t last for long in an environment of reduced demand.
This state of suspended animation applies as well to corporate America, which has benefited from the Federal Reserve’s dramatic cuts in interest rates and moves to support credit markets. A Bloomberg analysis of financial data for 3,000 of the country’s largest publicly traded companies found that 1 in 5 were not earning enough to cover the cost of servicing the interest on their debt, rendering them financial zombies.
Collectively those companies—among them Boeing, Delta Air Lines, Exxon Mobil, and Macy’s—have added almost $1 trillion in debt to their balance sheets since the beginning of the pandemic.
At the Salvation Army in Butler, evidence of this odd equilibrium can be seen in requests for food assistance. They’re down this year, largely because of drive-through distributions done by other charities in the Pittsburgh area. That doesn’t mean all is well. Applications for help paying for heating and other utility bills are up 50% from last year, says Darlene Means, who runs the local chapter of the charity with her husband.
Fewer petitions have been filed in the U.S. Bankruptcy Court’s Western Pennsylvania District than last year, but signs of how the crisis is rippling through the local economy can be found in its records.
Ed’s Beans Inc., a coffee roaster in Cranberry Township that owns the regional Crazy Mocha chain, filed for bankruptcy in October. The company secured a $506,200 PPP loan in early April, but it succumbed to the reality that fewer people going to the office meant fewer cups of coffee sold.
It owed millions of dollars to creditors, including almost $39,000 to a local bakery renowned for its doughnuts. In November, it asked the court to allow it to stop paying rent while it looked for a buyer for the Crazy Mocha chain.
Just seven of its 23 stores were open for business. But it wasn’t willing to give up on the closed stores, leaving those locations in their own undead state. “The debtor submits that reopening the closed locations at this time is not financially advantageous,” the company’s lawyers wrote. Owner Ed Wethli declined to comment.
Barkham thinks that pattern will be replicated on a wider scale next year. As the economy comes back to life and government support eventually is withdrawn, one effect is likely to be a surge in bankruptcies and evictions, he says. Even if vaccinations reach a meaningful number of Americans, it may be too late for many businesses.
It’s not clear how long Kriess, the memorabilia dealer, will be able to stay on his feet in the zombie recovery. He says he hopes to bring the museum back to life next year in the Monroeville Mall, where in early November he opened what for now amounts to little more than a kiosk selling T-shirts. He’s also planning a July 2021 festival.
Any return to the ambitious goals from the start of the year seems far off, though. He needs zombie tourists to come back to Pittsburgh. He also needs to be able to travel to fan festivals and industry conventions, which accounted for a significant portion of his income. “If the conventions don’t come back for a while, it’s going to be a struggle,” Kriess says. “If they do come back, and the vaccines work, then we probably will go back to normal. But that’s still to be seen.”
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