Fear of Japanification and the Rise of Zombie Firms
Japan’s Nikkei 225 Index has yet to recover from its market crash. Not the crash caused by COVID-19, the crash of 1991. In the 29 years since, Japan’s economy has experienced lackluster growth, deflation, and the rise of “zombie” firms that live off of cheap debt, a phenomenon now known as "Japanification.” Despite the Bank of Japan cutting rates from 6% to 0% over the next decade, pioneering quantitative easing and Abenomics, economic growth remains elusive. Lawrence Summers, a former National Economic Council director, has been warning that Japanification is in store for the rest of the industrialized world for some time, and now we’re there. If we are in an era of North American Japanification, in the midst of a depression, high-yield fixed income markets seem overly optimistic. Complacency should not allow cheap money to repeat the mistakes made before the Great Financial Crisis.
In September, American high-yield (junk) debt issuance hit a new annual record of $329.8 billion with plenty of room left in the calendar year. From 2008 to 2018, US economic output was below potential GDP, inflation remained muted and growth was below trend. Just two months before the pandemic, policymakers were concerned that monetary policy would not have the firepower to fight another crisis. Accelerated by the current crisis, these trends evidence the transition towards Japanification in America.
In the 1980s, the world thought Japan would rival the US for economic predominance, no one could have predicted Japan’s economic collapse. After Japan’s economy slowed dramatically for no apparent reason, the world got nervous. Looking for answers, economists turned to the theory of Secular Stagnation, used to describe the Great Depression. The theory depicts a slow-growing economy that is dragged down by a lack of consumer spending, a falling neutral rate of interest, and shrinking demand for investments relative to savings. Monetary policy has not seemed to work in Japan leading several experts to advocate for massive fiscal expansion, regulatory reform, and a more progressive tax system to close the investment-savings gap and raise the neutral rate of interest. Since 1981, interest rates were consistently lowered after each recession in an effort to stimulate growth. As a result, the bonds saw a 40-year bull market.
Four decades of falling rates and the Greenspan Put, an implicit guarantee to backstop financial markets with Fed intervention, have created a once in a lifetime opportunity for zombie firms to proliferate. These firms dramatically slow productivity because they are inefficient and use resources that could be used profitably somewhere else. Typically, inefficient firms cannot survive because costs outweigh revenues. However, cheap financing permits these firms to survive which slows the overall efficiency of an economy.
During 2008 and 2020, markets witnessed massive central bank interventions, saving many firms from bankruptcy, and creating zombies leading some investors to worry about growing default rates of the coming decade. In 2016, The Bank of International Settlements estimated the share of zombie firms in western countries had risen from 1% to 12% since 1990. With a growing number of companies unable to meet their interest payments without additional financing, it seems counterintuitive that bond yields near all-time lows after a short-lived spike in March.
Interventions by the Fed and the expansion of the money supply have buoyed financial markets and created a risk-on feel among investors who scramble for yield. The falling supply of safe assets has led many investors to purchase junk bonds that have completely unpredictable default rates in the new economic environment. When junk bond yields are so low, investors implicitly bet on one of two outcomes; additional Federal Reserve purchases will backstop the market if defaults rise or that default and recovery rates will improve over the last decade. The latter seems quite unlikely as investors’ concerns grow and the S&P warns of default rates rising due to the COVID recession.
Secular Stagnation compounds the risks. The bond market will have to rely more heavily on monetary expansion to secure refinancing rather than organic economic growth to service debt. Guessing the Fed’s actions rather than evaluating the soundness of enterprise detracts from the benefits of efficient and competitive free markets. Last month, US bankruptcies have hit a pre-virus low. The pandemic is not behind us. However, investors are allowing companies that would otherwise go bankrupt to survive because valuations fail to consider if the availability of credit were to revert to pre-crisis levels.
The unloved market rally of today mirrors the melt-up of the previous decade after 2009. The abnormal disconnects between the economy and markets may lead people to believe investors are too optimistic or out of touch with the economic situation facing so much of the world. This does not consider that the biggest investors need to invest. Pension funds, mutual funds, and other investment firms will not make any money if they hold cash or be able to justify the hefty fees they charge their clients. Clients who depend on their success for retirement or other large expenses. The shortage of safe assets has driven many investment firms to chase yield around the world.
The market was here before; yields around the world were at thirty-year lows just after the Fed decreased rates in the wake of 9/11. With a high demand for safe assets going unmet, banks had the short-sighted idea to expand their Mortgage-Backed Securities business. This was meant to supply the clients with a safe alternative to sovereigns and AAAs to invest their savings. Over the next few years, aggressive lending fueled the optimism that housing prices would rise indefinitely. Housing became the backbone of the American economy and global financial system. Western economies were decimated after housing prices fell. Today, market participants are confronted with lower rates and greater risk. The is yet again a shortage of safe assets. Harvard economists Carmen Reinhart and Kenneth Rogoff’s recent publication outlines growing risks in sovereign debt markets which push investors to seek alternative safe investments.
In a world of cheap financing and slowing economic growth, credit analysis must clearly distinguish between winners and losers to kill off those zombie companies that the world no longer needs. As investor demand for safe assets goes unmet, many are turning to more risky debt as treasuries yields are negligible. Secular stagnation must be addressed as it poses substantial risk to bond markets. Falling demand will result in falling revenues that increase default risk. Complacency and Fed reliance only risks another credit fueled economic meltdown.