An economic paradox is playing out before our eyes. For more than a year now, restaurants, hotels and other businesses in the service sector have had to either close their doors or suffer a drastic drop in income due to the continued lockdowns. Yet when we walk past, say, a big chain hotel, the lights always seem to be on. Unless we assume that these companies have discovered a way to turn lead into gold, one wonders where the money is coming from.
To answer this question, we need to dive deep into the financial markets. In a dark corner of these markets we find an asset class known as junk bonds. Junk bonds – sometimes politely called “high yield bonds” – usually have very high interest rates and low credit ratings. This means that the companies issuing the bonds are seen by investors as having a high chance of going bankrupt, so the companies pay very high interest rates to borrow money. The junk bond market works because investors can afford the very high default rate thanks to the high interest rate paid.
Since March of last year, when the shutdowns began, the junk bond market has gone wild. Usually, in the market, the interest rate increases when the bankruptcy rate increases. Bankruptcies soared in March last year and junk bond interest rates rose. But then something strange happened. Bankruptcies remained high, but junk bond interest rates fell to record lows. Why?
There seem to be two forces at work. The first is the Federal Reserve. As the shutdowns began, the Fed began to embark on its most dramatic and ambitious asset purchase program to date. Exceptionally, he even dipped his toe in the junk bond market– something unthinkable before. Meanwhile, after a brief crash, the financial markets began to go haywire. Bubbles have started to swell in market after market – we all see the chaos in the Bitcoin market, but many don’t know it the S&P500 is now more overvalued than at any time since the dot-com boom of the late 1990s and early 2000s.
The second was that when markets go manic, investors go hungry. They are looking to pump more and more money into more and more markets. Caution is thrown to the wind. Risky assets are recovered as if they were US Treasury bonds. The Fed’s drive to enter the junk bond market gave manic investors the excuse they needed. They piled up and pushed borrowing rates to historic lows, even as bankruptcies remained high and clearly had the potential to rise.
In March 2021, the Bank for International Settlements published an article which has received far too little attention. The authors noted that, relative to the magnitude of the economic downturn, too few businesses were failing. They dug into why that was, and lo and behold, they discovered that corporations were exploiting the credit markets. They were borrowing to keep the lights on. Specifically, they found that the businesses at risk were from the “airline, hotel, restaurant and leisure sectors” – all those sectors heavily affected by the shutdowns.
Looking at the research and the markets, it appears that investors have some sort of rationale for this massive increase in lending at historically low interest rates. They seem to assume that the post-COVID rebound in service sectors will be nothing short of magical. Yet even thinking about it for a moment suggests that this rationale is absurd.
First, there is the question of whether vaccines will bring about the long-awaited return to normalcy. The efficacy of the vaccine seems decline overtime. Some still hope vaccines will prevent another shutdown this winter, but examples like Florida throw cold water on those aspirations. Florida has more than 80% of its vulnerable population fully vaccinated, but this summer has seen hospitalization rates that rival pre-vaccinated peaks.
But assuming that vaccines manage to control the virus, would we really see the resumption of services that the markets are hoping for? It seems unlikely. A lot of people are truly terrified of this virus, some to a completely irrational extent. It could take years for these people to return to a normal life. This means that the affected sectors will see fewer customers than before the pandemic. This does not bode well for an industry rebound.
So what if markets become less bullish, junk bond interest rates rise, and we see a wave of defaults? Something remarkably similar to what happened in the mortgage-backed securities market in 2008. Bonds that investors consider relatively safe would turn into toxic sludge, and anyone holding them would lose their shirt. Meanwhile, in the real economy, companies that eventually defaulted and went bankrupt would lay off their staff.
Running a few numbers on this possibility yields frightening results. The vulnerable sectors in 2008, real estate and construction, accounted for about 3% of total employment in the United States. Vulnerable sectors today – leisure and hospitality, air transport and arts and leisure – account for more than 5% of total employment. It is true that layoffs in a massive bankruptcy scenario might be less severe this time around than they were in the real estate sector in 2008, but the fact that there is a larger pool from which to lay off should make us nervous.
What would trigger such a crash? A mouse to scare the market elephant. Markets are almost certainly deep in the latter stages of a bubble. At some point, something will scare them. A little more inflation, perhaps; perhaps the threat of a Fed hike; or perhaps a prolonged failure to bring the virus under control. Your guess is as good as mine. But what goes up must come down. And if this thing goes down, it seems likely that the junk bond market will go down with it. Then we could be facing another full-scale financial crisis. Hang on.
Philip Pilkington is a macroeconomist with nearly a decade of experience working in investment markets, he is the author of the book Reform in economics: a deconstruction and reconstruction of economic theory.
The opinions expressed in this article are those of the author.