Economic history might be repeating itself in the United States. Once again a deluge of cheap debt created by the Federal Reserve’s low interest rates is having some very destructive effects upon America’s economy.
This time around it is businesses; particularly manufacturers, entertainment companies, and retailers, that are gorging on cheap debt they might never pay off. Investors need to pay attention to this situation – because there is strong evidence that America’s booming stock market is being driven by cheap debt rather than increased earnings.
The poster child for this phenomenon is Elon Musk’s electric-car company Tesla Motors (NASDAQ: TSLA), which was trading at $366.45 (€286.72) a share on 2 October 2, 2017. That was inspire of a $766.13 million (€652.89 million) loss and a -$294.54 million (-€251 million) cash from operations figure on 30 June 2017.
Tesla and Wall Street’s dirty secret a junk-bond fueled rally
The dirty secret to Tesla’s survival is borrowing; it raised $300 million (€255.66 million) by selling $1.8 billion (€1.53 billion) worth of 5.3% yield junk bonds in August, The Street reported.
Tesla led a stampede of corporate borrowers that raised $17.65 billion (€14.96 billion) in junk bonds by 18 August 2017. The amount of junk bonds sold in August 2017 was nearly 17 times that sold a year earlier when companies bought $865 million (€737.14 million) worth of such paper in August 2016.
The borrowers were rushing to take advantage of cheap credit in anticipation of an interest rate increase by the Federal Reserve. Junk-bond rates were expected to increase to 6% to 7% after Fed action.
Disturbingly junk bonds might be the only thing keeping Tesla in business. Musk can keep losing money because he can borrow more at low rates. This enabled the billionaire to build his car factory, and his enormous Gigafactory battery plant in Nevada. The availability of cheap junk bonds might be the only thing keeping Tesla going.
“The Federal Reserve has created the environment for Tesla stock to flourish without needing any financial metrics to back it up,” Seeking Alpha writer Parke Shall noted. Shall’s thesis is that the high US stock prices are a result of Federal Reserve policy – not economic performance.
The Havoc Cheap Debt is Wreaking on America Retail
Intriguingly Tesla’s overpriced stock far from the worst effect of such cheap debt. Even if it collapses, some other company; such as General Motors might buy the factories, technology, and brand and keep making the vehicles.
The worst effects are in retail where a number of companies have remained in business long after they should have shut down. A classic example is the Bon Ton Stores (NASDAQ: BONT), a department operator so sick its stock was trading at 43¢ (€0.37) a share on 2 October 2017.
Despite that; and a $77.39 million (€65.95 million) loss, reported on 31 July 2017, Bon Ton announced plans to hire 10,000 additional workers for the 2017 season. Skeptics might want to know how Bon Ton plans to pay those additional employees if it is losing money. The answer is simple it borrowed, or will borrow, the money.
Bon Ton reported raising $21.09 million (€17.97 million) in cash from financing on 31 July 2017 even though it lost money from its operations. The company borrowed that money to keep itself in operation and it is far from alone.
Is Cheap Debt Keeping America’s Worst Retailer in Business?
An even sicker retailer, Sears Holdings (NASDAQ: SHLD) which has plans to close up to 330 stores this year, reported raising $547 million (€466.15 million) in “cash from financing” on July 31, 2017. In other words, Sears borrowed $547 million (€466.15 million) it can probably never pay back.
On the same day Sears reported a loss of $1.362 billion (€1.16 billion) instead of an income. It also reported losing $1.879 billion (€1.6 billion) in cash from operations. The only way Sears is able to get away with this is cheap junk-bond financing.
That financing partially explains all the videos of creepy Sears’ stores that are filled with merchandise; but completely devoid of customers, one finds on YouTube. Retailers like Sears and Bon Ton can sustain their operations; perhaps indefinitely, through borrowing.
That harms communities and shopping-center owners by saddling them with big, empty stores that attract no customers and generate no sales-tax revenue. Many landlords would love to throw retailers like Sears out; but cannot because of leases in which the rent is a percentage of the store’s revenue. If the store makes no revenue, it is staying almost rent-free.
Such arrangements have allowed Sears owner and CEO Eddie Lampert to shake down mall owners. Lampert makes money by forcing the owners to pay him to move his store out of the mall. To make matters worse, Lampert has transferred much of Sears’ real estate to his investment trust Seritage Growth Properties (NYSE: SRG); which leases or sells former Sears’ locations to other successful retailers.
Potentially Disastrous Stimulus by Debt
The situations at Sears, Bon Ton, and Tesla show how junk-bond debt functions as a sort of stimulus in America.
Companies borrow money at low interest rates and use it to cover the salaries of additional employees. That creates a few jobs in Middle America and stimulates just enough economic activity to stave off civil unrest.
The hope is that will put enough money into the economy to generate some economic growth. It also raises serious questions about America’s economy, is the ongoing recovery fueled only by cheap debt and will it collapse when that debt disappears.
Debt-Fueled Bubbles Everywhere
Much of the economic growth in the United States is financed by cheap debt which is starting to produce bubbles. Not surprisingly, one of the worst bubbles is in Hollywood where television producers are among the biggest debt addicts.
There were 455 scripted shows on American television in 2016 compared to 192 in 2006, Variety reported. The vast number of shows only exists because producers can get very cheap financing. It is easy to see why John Landgraf the president of the FX network is worried about “Peak TV.”
Are there enough couch potatoes on Earth to watch all that television? Nobody knows; but things might get worse, Variety speculated that the number of scripted shows might hit 500 in 2017 because of digital outlets like Netflix (NASDAQ: NFLX). That’s good news for actors that need work, but how long can it last.
Nor is it just in television, Amazon (NASDAQ: AMZN) now operates 80 fulfillment centers in the United States and seems to be opening a new one each week. The online retail giant is planning to build a second headquarters that might employ up to 50,000 people. If that was not enough, Amazon purchased the grocer Whole Foods for $13.70 billion (€11.08 billion) in August. All that expansion is being financed with cheap debt.
Dollar General can open all those stores because it can borrow vast amounts of money through junk bond debt. Dollar General reported a net income of $1.224 billion (€1.04 billion) on 31 July 2017, which is far from enough to cover those expansion costs.
Is all this expansion sustainable without cheap debt? Nobody knows, but the situation has an eerie similarity to the housing market circa 2005 – when homebuilders were constructing more homes than they could sell. That led to mortgage abuses; such as the infamous Ninja (no-income, no job) loans, many of which were never paid back.
America is Wallowing in Cheap Debt
The United States like the Peoples Republic of China is wallowing in cheap debt that may never be paid back.
The difference is that the Chinese seem to have gotten something for their debt – namely new high-speed trains, highways, and cities. All Americans might get out of their debt binge is lots of empty fulfillment centers, vast amounts of video nobody watches, and thousands of closed stores.
Investors should pay careful attention to this situation, because the U.S. stock market bubble is partially driven by cheap debt. When the cheap debt ends, the bubble might burst, stocks might collapse, retailers will contract, and the United States will face another economic meltdown similar to that of 2007.
The obvious question to ask here: is will Americans ever learn about the dangers of cheap debt? More importantly, when will U.S. policy makers learn that cheap debt is no substitute for real economic stimulus? Recent history indicates that neither lesson has been learned and may never be learned in Washington D.C.