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  • Writer's pictureEdward Ballsdon


Updated: Jul 18

Over the last week volatility has declined across many asset classes, with some further small price gains in stocks and investment grade corporate bonds and relatively unchanged prices in DXY, 10year government bonds (UST/Bund/Gilt), JPM EM Currency Index, Gold and even Oil.

This note looks at how very large government intervention through fiscal policy, financed by a large expansion of central bank balance sheets has allowed for this reduced volatility. This action has purely changed valuations, not the underlying leverage positions of balance sheets. That said, this intervention is different from that seen in Japan in the 90s, which should lead to different asset price valuations, but nevertheless this pandemic is casting light on recent balance sheet transactions which might lead to different corporate behaviour in the future.


The USA started the 1970s with the USD and money supply tied to Gold. The USD devalued to Gold in 1971, and it finally broke free in 1976. Expansive fiscal policy occurred twice in the 70s, which coincided with a rise in yields which enticed private savings to fund the deficits (decades before Fed debt monetisation). The shift of savings from the private to the public sector coincided with a revaluation lower of equity prices (-46% and -20%).

Why was there no meaningful equity correction in the 1992 Reagan inspired 5% deficit, or the 3.5% deficit that GW Bush inherited in 2004? The chart below shows the expansion US bank and household debt, with the green circles highlighting the deficit years. Two points stick out. 1) The deficits were not as large, and 2) just as importantly, unlike in the 70s, when there was a sharp reduction in credit growth rates, the 90s and early 00s saw stable credit growth rates.

Source Fed Flow of Funds

But then something changed around the GFC – bank balance sheet leverage contracted for the first time since 1945, as did household (HH) leverage. The chart above shows how the stock of outstanding Bank and HH debt declined for the first time post war. Without private sector credit expansion, increased demand for private sector funding of large government deficits would have to come from the private sector’s existing investments, so either from cash holdings (which tend to be sticky) or from selling other investments.

The government or the Fed could not afford to have yields rise, so they countered the lack of private sector credit expansion with the Fed’s own balance sheet expansion, and that stopped real yields rising – indeed they dropped from +2.0% to -0.85% between the start of QE1 and end of QE2 during which the Fed purchased $1.2trn of US federal debt, roughly 1/3rd of the $3.5trn supply.

The Fed also had a huge hand from another funding source – foreign savings (predominantly foreign central banks). As can be seen from the chart below, when the net supply increased between 2008 and 2011, foreigners purchased between 40 and 50% of the annual issuance. Domestics had to absorb a relatively small proportion.

It is clear how debt supply and demand dynamics have changed over the last 50 years. The relationship between government deficits and bond yields and equity valuations used to hold true until private sector leverage boomed, no doubt in large part due to over easy monetary policy. But when deleveraging occurred in the GFC, the FED was forced to step in and part finance the government, otherwise deeper private sector asset price losses would have materialised. The same can be said for other economies, eg Japan, Eurozone and UK, where CBs enacted QE to finance increased deficits, sparing the need for private savings to fund government expenses.


The targeted assistance in response to Covid19 is no different to that of the GFC, except that a) the response time has been so much quicker and b) there will be more assistance to corporates. As I highlight in my weekly update on US Treasury Supply and Demand, the large rise in government bond supply is being met by a rise in Fed demand for that supply, meaning that private sector funds are NOT required to fund the deficit, leaving private sector assets, after the initial panic, to remain relatively unaffected by the government deficit.

Furthermore there is the promise of other government assistance to private sector assets, in the form of 1) direct disbursements from the government (e.g. wages and salaries), 2) indirect help through bank loans, where potential losses will be backstopped by the government, or 3) from the Fed, who has largely been guaranteed by the US Treasury (i.e. backstopped by the government) – full Fed tools are listed on their website:


This assistance is where policy diverges substantially from Japan in the late 90s. Whilst there was a substantial rise in Japanese fiscal policy, the credit sector remained predominantly in the hands of the very under capitalised banking system that had absorbed large losses on investments and suffered from high NPL provisioning. It was only in 1998, some 8 years after the peak in the Nikkei, that the Japanese government intervened to help banks restructure and get credit markets functioning again.

In those 8 years two very important behaviours took place:

  1. Banks were willing to lend to counterparts who did not want to borrow, despite 0% interest rates, whilst willing borrowers could not source loans as banks deemed them uncreditworthy.

  2. Banks “evergreened” loans, i.e. they did not classify impaired or non performing loans as such, reducing the need to provision for them, thereby making their capital look far more adequate than it actually was. An under capitalised banking system will not/cannot lend new money.

The combination of private sector deleveraging that resulted from the above two factors and the ballooning government deficit (from +2% /GDP in 1990 to -10.25% in 1998) combined and contributed to reduce the velocity of money supply, reduce the value of private equity (Nikkei – 65%) and collapse substantially over inflated property values.

The current willingness of governments around the world to backstop bank lending to the private sector should to some extent limit the rise in bank NPLs, whilst the relaxation of capital requirements is aimed at stimulating fresh lending. Meanwhile Central Bank funding of government deficits will go a long way to limit the requirement of private sector assets to fund governments. This is clearly why risk assets have not declined as much as they would have if the private sector had to finance the deficits without central bank help.

Or put another way, would governments have announced such large fiscal stimuli without the knowledge that central banks would have printed money to buy that debt? If they didn’t do such large fiscal expansions, then undoubtedly bank NPLs would have risen substantially and private sector assets would have revalued lower. If they would have done a stimulus without central bank funding, then the real yield rise in March gives a clear indication of what would have happened to bond yields, which would have brought carnage to private sector debt markets (and thus equity as well).


Another of the big lessons from the GFC was to understand clearly what governments and central banks will do, not moralising over what they should do. That was the basis of my call on a post a month ago that central banks would step in and cap the rising real yields, which would lead to lower financial market volatility. This lesson was learnt! Being bearish risk assets is fighting actors who are deploying gigantuan balance sheets.

Whilst lowering volatility, this market episode has nevertheless exposed some corporate practices that market participants, policiticans and regulators have started questioning whether they will occur in the future. There are others which have not yet been raised but will become an issue in the future. I have identified two that will have consequences for investments in risk assets, be they made by the Fed or by the public sector : Goodwill and Intangible assets, and Use of Cashflow.

1. Goodwill and Intangible Assets.

Intangible Assets are assets on a company’s balance sheet that are not physical in nature but are deemed to have a value, for example patents, brand names and Goodwill. Goodwill is an intangible asset that is associated with the purchase of one company of another. These items are given values because debt has been raised to either develop them or buy them – if no value was ascribed to them, they would have to be written off in the P&L and thus reduce equity capital.

To determine the true net value of a company, i.e. its real shareholders funds, a Credit Loan Officer would nearly always deduct intangible assets from a company’s equity (at least that’s how I was trained and taught!). The reason is simple – if a company goes bust, intangible assets can become worthless and are unlikely to be able to be used to offset debts. Brand names can sour very quickly (Ratners, Perrier), as can technology (e.g. Palm, MySpace, Kodak), and a company that was bought by someone at a premium might not be worth that premium to another (e.g. Dotcom, Countrywide).

In 2010, when I was warning about the fragility of Italian and Spanish banks, I highlighted that the largest 5 Italian banks had €142bn of capital, but this was inflated because they also registered €50bn of intangible assets in the form of Goodwill (the Spanish top 5 had €154bn of equity and €36bn of intangibles). They were hugely undercapitalised against the risk of NPL increases. The Italian banks were subsequently forced to raise substantial capital and their Goodwill values were valued at a mere €11bn by 2013. When things get tough, intangibles get valued lower, and the corresponding balance sheet decrease on the liability side of the balance sheet is equity, due to the revaluation lower of Goodwill impacting P&L and thus the Retained Earnings component of Shareholders funds. Because equity is the denominator of the Debt/Equity equation, when the tide goes out and financial markets have a tumble, the true state of (much higher than expected) leverage gets found out.

2. Cashflow

Much has been made about zombie companies whose cashflow can only service interest costs but not repay debt. There is also a lot of noise regarding share buybacks and whether companies should be bailed out if they have undertaken buybacks. The answer to this second question is absolutely yes, but the real question should be on what terms!

Zombie debt servicing and buybacks are very similar behaviours when looking at cashflows – and they both result in higher leverage. There are numerous cases where positive operating and investment cashflows then become negative after dividend and buybacks, necessitating an increase in debt (and this leverage). This simple buyback leveraging of balance sheets has been much discussed, but when you factor in intangible assets highlighted above, then the issue gets magnified.

To demonstrate this, below are excerpts from financial accounts of three different companies that are included in the CDX investment grade index. Baxter was chosen as its CDS trades at a very low 16bp, whilst Caterpillar and Boeing were picked as they have recently been in the press. There are some very key issues that can be seen from looking at this data:

  • In the three years the 3 companies generated a combined profit before tax of $35bn (of which $ 20bn was from Boeing), and yet the equity book value of the three companies declined by $13bn.

  • Over the last three years, all three posted large positive cashflows after investments (only exception is Boeing in 2019). And yet the combined cost of dividends and share buybacks was generally larger than that net cashflow, requiring an increase in debt to fund the dividends and buy backs.

  • All have large amounts of Intangible and Goodwill assets, which substantially reduce their true net Equity values.

  • Whilst Baxter’s net leverage is manageable, it has increased substantially despite making very good profits.

  • Caterpillar’s leverage at ~315% is high. Is it a zombie company because it is not repaying debt, despite ~$5bn of cashflow, because it has to pay dividends and its own equity?

  • Boeing has seen substantial rises in net indebtedness, despite the positive $18bn cashflow story over 3 yrs. It obviously has its own problems given its negative equity and negative cashflow, surely two things not normally associated with the term “investment grade”!

The Caterpillar 1Q20 results show that their cashflow policy has not changed since the outbreak of Covid19. Cashflow is negative necessitating a rise in debt and in net leverage to fund dividends and buybacks.

Source : Baxter Website Caterpillar 10-K Boeing Website

These are investment grade companies with credit spreads ranging from 15 to 350bp. Whatever the government might do to assist these companies will not improve their leverage positions – if anything it will more likely deteriorate.


It is becoming clear that support for the time being is at best debt (or debt substitution from the market to the Fed, backstopped by the US Treasury), and not non-repayable grants. Debt dynamics on ever leveraging balance sheets suggest that CBs will have to always do more to support corporate debt, on top of the support that they will have to provide governments.

When there is a return to normality, corporate America will find itself in an even more leveraged position than the already highly leveraged position it was pre Covid19, which means that the rebound in equity and tightening of credit spreads will make these assets even more highly “valued”.

The misallocation of capital during the Japanese evergreening years had some very important consequences on growth and inflation, which are very well documented in various research papers (see BIS, NBER etc). The potential transfer of credit risk from the private to public sector through the government backstopping of bank loans, as well as the risk of good money being lent to bad, opens up Central Banks to the accusation that they will be carrying out an equivalent Evergreening of corporate debt as well as a not stemming the misallocation of capital that has allowed the rise of zombification, not only of negative but positive cashflow companies. I cannot think of anything more opposed to the doctrine of “Creative Destruction” laid out by Joseph Schumpter.


My core views remain that interest rates will remain “lower for longer”, supported by QE that will suppress real rates. For the time being, recent CB policy and statements don’t threaten that view, nor does the economic data being released. If anything, potential private and public sector debt increases cement that view.

The same goes for Gold – more CB intervention and support, necessitating a further increase of money supply above and beyond what the market expects, should support the value of precious metals. The significant decline in oil prices should finally allow the relative cheap miners to start outperforming gold – energy is a significant cost to gold extraction. The ratio of gold miners to gold is currently very depressed - chart below – finally there seems to be some miner outperformer (the ratio momentum has resumed its uptrend).

Equity and Credit markets remain a play on believing in

  • Continued government intervention to support credit.

  • Central bank intervention to support government financing.

  • Credit markets remaining functional to allow refinancing of leveraged balance sheets.

This is a form of Central Bank Evergreening. Current policy supports all three of those beliefs.

The key one that could change on a dime is the third – it relies on market confidence that companies will continue to pay dividends and coupons, banks will play their part and lend as expected by governments, and that governments will not extract conditions for support which are to the detriment of equity and bond holders (e.g. higher taxation, regulation).

Risk reward seems low given current valuations, but the same could be said over the last 4 years when both asset classes have performed exceedingly well.

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