Bridgewater Associates — one of the most successful hedge funds in the world by dollar volume of profits since 1975 — is warning of a potential “lost decade” for stocks.
“Globalization, perhaps the largest driver of developed-world profitability over the past few decades, has already peaked,” said Bridgewater analysts in a June 16 note to clients, as reported by Bloomberg.
“Now the U.S.-China conflict and global pandemic are further accelerating moves by multinationals to reshore and duplicate supply chains,” they add, “with a focus on reliability as opposed to just cost optimization.”
The problem is a double whammy of falling profit margins and rising debt levels.
When a company carries more debt than before, while taking in less revenue and booking less profit, the valuation multiple tends to contract.
That combination of reduced revenue and increased debt is more or less happening now, in the context of trends that will last for years (if not a full decade or more).
For example, if globalization stalls out or partially reverses, that is bad news for the big multinationals in the S&P 500, who earn close to half their revenues overseas.
It would also be bad news for Just-In-Time (JIT) supply chains, a key point emphasized by Bridgewater.
Global supply chains tend to spring up organically because they increase profits. Lower production costs via global suppliers translate to larger profit margins per dollar of revenue earned. If this were not true, the use of such chains would not be popular in the first place.
Now, though, a great many supply chains are broken, or otherwise in a state of disrepair, because of disruptions caused by the pandemic. This speaks to the vulnerability of the setup: If you remove a single link in the chain, the whole thing shuts down.
Not only are supply chains being broken, companies are uprooting far-flung supply chains and bringing production efforts back home. The threat of trade war on multiple fronts — not just between the U.S. and China, for example, but also the U.S. and Europe — is accelerating this trend.
In comparison to the typical global supply chain, a home-based supply chain is more robust, less exposed to pandemic-related issues, and insulated from trade-war fallout. And yet, making stuff at home tends to cost more.
For products that are made in the United States, labor costs will generally be higher than they were overseas. The duplication of single-point supply chains, now urged for safety’s sake, also adds to the cost of production.
All of this comes against a backdrop of rapidly rising corporate debt, with total corporate debt levels rocketing to previously untold heights in the pandemic.
In the 1950s, the average debt level for U.S. corporations hovered around 40% of corporate net worth. By 1990, this had risen as high as 94%.
Corporations then went through a 20-year period of deleveraging in terms of debt load relative to net worth. This lasted until 2010, when corporate debt levels bottomed out at just below 63%. From there, corporate debt rocketed higher over the next 10 years, cracking 130% by the fourth quarter of 2019.
The total value of commercial and industrial loans — another measure of corporate indebtedness — has also skyrocketed. In December 2010, the total volume of commercial and industrial loans was about $1.1 trillion. By December 2019, lending volume had more than doubled, to $2.3 trillion.
And then lending volumes shot straight up, cracking $3 trillion as of May 2020. After taking a decade to book a 100% increase, another 30% increase was layered on in the space of just five months.
The corporate debt frenzy is still on full blast, thanks to the corporate bond-buying promises of the Federal Reserve. June 2020 is on pace to be the busiest month in history for junk-bond issuance.
“Companies are looking to raise money now since they don’t know how long this window of opportunity will last,” Bloomberg reports, “especially if a second wave of coronavirus cases hits later in the year. Bankers have been encouraging their clients to raise money now in case things get worse.”
So, we know profit margins are getting squeezed, as a result of supply chains being broken or disrupted. We know production costs are rising, as a result of supply chains being duplicated or relocated to home markets.
We also know trade-war pain is an increasing factor, along with reduced demand as a result of global slowdown. (Angela Merkel, the Chancellor of Germany, warned on June 18 that Europe is facing its worst recession since World War II.)
And against this backdrop, we know corporate debt levels are exploding — a trend that had already been building for a decade, with corporations borrowing large sums at near-zero interest rates to fund the purchase of share buybacks.
Now, though, corporations aren’t borrowing to buy back shares — they are borrowing out of fear, in part because the Federal Reserve has thrown open the free-money window (through the implied promise of total market support) and because they don’t know what challenges are coming next.
Then, too, we know U.S. corporate profits have been flat for eight years, stuck in a sideways range since the first quarter of 2012. The appearance of rising earnings those past eight years was largely financed by share buybacks enabled by debt.
Last but not least, we know that “zombie” companies are starting to roam the landscape. These are entities that, in a free-market economy, would technically be dead, yet stay alive through artificially cheap funding and backstopped government support.
Zombie firms sap the vigor of an already weak economy, making it that much harder to return to real growth. Their presence is especially worrisome when consumers are hunkered down, saving for a rainy day and paying off debt.
Add it all up, combined with some of the most expensive market valuations in history, and Bridgewater’s “lost decade” warning for stocks looks plausible indeed.
It is not hard at all to picture the major U.S. indexes going nowhere for 10 years straight — or alternatively, seeing stocks rise to new heights in nominal terms, but staying flat or losing ground once nominal values are adjusted for inflation.
Japan is once again worth keeping in mind here: Japan’s bellwether Nikkei 225 index peaked in December 1989 and, more than 30 years later, it has never come close to those highs.
Not to mention that, in the United States, after the stock market fell to its Great Depression lows in 1932, the Dow Jones Industrial Average did not regain its inflation-adjusted high until 1954 — a full 22 years later.
All in all, we had better believe a “lost decade” can happen here.
And if it does, then just like in the 1930s and the 1970s, we’ll want to be long assets that benefit from aggressive currency debasement — because central banks and governments will be actively destroying their currencies in an effort to solve the problem.