Worried about debt? Equity investors should be

Worried about debt? Is it all getting too much? Want to have it all written off? Recently, my mobile phone has started receiving “spam” text messages to this effect – which has been causing me mild irritation. Where do these people get their numbers from? How do I block them? Have I inadvertently assigned them to Speed Dial 3?

But how others react to debt worries can be more instructive. And it seems there is now a marked difference in the attitudes of UK householders, multi-millionaire motorcyclists, bond fund managers and US equity analysts.

Last week, while on holiday, my BlackBerry brought news of payment protection insurance (PPI) compensation, home repossessions and insolvencies. Together, it suggested that millions of homeowners are still worried about debt. Where do I get my numbers from? Well, the banks have acknowledged that at least 1.5m people were missold PPI. However, the fact that there are 16m policies in existence suggests that some people genuinely want insurance against becoming overstretched. Similarly, the Council of Mortgage Lenders’ data for the first quarter showed repossessions down 10 per cent year-on-year, suggesting homeowners and lenders have used low interest rates to better manage repayments. Government figures also revealed that personal insolvencies were down by 15 per cent over the period.

A perusal of the Reuters and FT.com mobile phone apps then showed that concerns over government debt levels are now at a record high. Where do I get my numbers from? Well, at the beginning of this week, Reuters reported that Jim Rogers – co-founder of the Quantum Fund with George Soros, and self-styled round-the-world “Investment Biker” – planned to short-sell US Treasuries, as the end of quantitative easing removes support for government bond prices. Bill Gross – co-chief investment officer of Pimco – had already reached that conclusion, increasing his short position in US government debt in April. As a result, short positions in six to 11-year US bonds are approaching the May 2008 record level of $32bn, according to the New York Federal Reserve.

But an earlier text message confirming a meeting with Andrew Smithers, of advisers Smithers & Co, led me to realise how blithely unconcerned about debt certain analysts seem to be. Smithers pointed out a worrying anomaly in the measurement of US corporate debt. Investment bank research suggests that the leverage of US companies – how much they are financed by borrowing – is historically low. But data from the US Federal Reserve show that leverage is within a few points of the highest it has ever been. How can this be?

Because investment banks only measure the debt of companies in an index. As Smithers points out: “Leverage does not fall just because GM falls out of an index.” He believes worried investors should look at companies’ cash to debt ratios. His analysis shows that cash levels have been a leading indicator of corporate share buying – and, consequently, stock market returns. At present, high corporate cash levels suggest that, even though US shares are 70 per cent overvalued on long-term price/earnings ratios, there is scope for them to rise higher.

When deleveraging begins, though – as it surely must – profits and prices are set to fall. US companies that don’t realise how leveraged they are will see margins revert to mean as interest rates rise – reducing their cash flows and their ability to fund share purchases and dividends with debt.

Earlier that same day, Jerome Booth of fund manager Ashmore, had noted that the deleveraging of the 1930s saw investment fall by 95 per cent.

Whether today’s global companies will be so constrained by debt is unlikely. Even so, if you get a phone call from a broker suggesting US stocks look cheap and under-leveraged, you might politely suggest he’s got the wrong number – and transfer him to the debt advice line on Speed Dial 3.


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