Our Most Serious Warning yet About the Looming Collapse in Corporate Credit

The real-world impacts of 'free money' central banking... How falling commodity prices will destabilize the system... Amazon versus Netflix: Who will lose?... Our most serious warning yet about the looming collapse in corporate credit...

In today's Friday Digest... something I don't think you've seen anywhere else before – the "butcher's bill" of our current economic policies.

We all know that printing money isn't a good economic policy.

If printing money worked for an economy, then Zimbabwe would be Switzerland and Argentina would be wealthier than the United States. Incredibly, the world's "smartest" and most powerful economic mandarins have all adopted debt monetization (aka quantitative easing) as their core economic lever.

Anyone with a shred of common sense... or any understanding of human nature (or history)... knows this won't work for long. After all, not paying debts is a lot easier and more fun than facing a sober and sound economic reality.

Alas, there is no Santa Claus.

And, sooner or later, global confidence in this gigantic paper-money swindle will disappear, like blowing out a candle.

The question is, what will trigger that "tipping point"?

I've got a few ideas...

(By the way, I think these ideas are important enough to share with everyone. Feel free to forward today's Friday Digest to anyone you think might be interested in these kinds of ideas. I am producing a YouTube video about these problems, too. Look for it in a few weeks.)

I haven't seen any serious writing about the long-term damage caused by the world's largest economic areas adopting "free money" (zero-percent interest rate) policies. Capitalism without interest rates isn't a free market. It's a Bizarro World where everything about how a normal economy works gets turned upside down.

Let's look at the harm these policies have caused to actual large companies and see where this Alice-in-Wonderland kind of economy will take us.

These for-profit companies aren't interested in profits...

The first thing I've noticed about the world since 2010 is that we now have virtually unlimited amounts of capital available for any company who wants to borrow it.

That's led to a huge expansion in the amount of junk bonds outstanding – including companies like oil-exploration firms that haven't normally had access to large amounts of long-term credit. (We'll talk more about that in a minute...) But the impact has been even more significant for "investment grade" credits. Here, virtually unlimited amounts of credit have become available for almost nothing.

In theory, the costs of doing business are limited to capital and labor. Technology has greatly reduced the labor inputs for most businesses. With nearly free capital and greatly reduced labor inputs... the costs of producing a widget or providing a service have plummeted across our economy.

That sounds great, right? Lower costs should equal bigger profits. But of course, there's also competition. When everyone has access to unlimited capital… and technology limits the per-unit cost of labor... economic theory suggests there will be a race to zero. No one will be able to make a profit because there's no scarcity of capital, and therefore no ability to increase relative productivity.

And... what has happened?

The last several years have seen the rise of companies that are experts at exploiting technology to reduce labor costs. Free capital and zero per-unit marginal labor costs equals a whole new form of capitalism that's genuinely unlike anything the world has ever seen before.

These are companies with massive scale, massive sales growth... and virtually zero profits.

Amazon (AMZN) is the most famous example. In just the last three years, the Internet retailer's revenues have almost doubled (from $80 billion to $140 billion). Meanwhile, its profit margins haven't budged. They remain less than 2%. With this kind of scale and almost no profit, Amazon has been able to grow faster and faster, into all kinds of new businesses. The company doesn't have to worry about cash flows to power investments into new lines of business because, after all, capital is free.

So even though Amazon has only earned profits of $3 billion over the last three years, it has been able to invest $17 billion into growing its core business and building new businesses.

I've never seen a company of this size borrowing such a high multiple of its annual net income to spend on capital investments. And I'm pretty sure nobody else ever has either. Just think for a minute about this...

On revenues of $320 billion... Amazon has only earned $3 billion in net income. Meanwhile, it has spent $17 billion on investments in just the last three years. It borrowed $7.5 billion in the last two years to help finance these investments.

The result of these kinds of ongoing massive investments is a company with a market cap of close to $500 billion... that has a lifetime, total combined, retained earnings of less than $5 billion. And since it has never paid a dividend, those are the company's total lifetime earnings.

It's a for-profit company that doesn't intend to make a profit. And it doesn't have to because there's unlimited amounts of additional investment capital, available essentially for free.

Sounds great... for consumers. But is it good for investors? Is it good for our economy?

It hasn't been good for IBM. In the face of competition from Amazon's Web Services business (its cloud offerings), IBM's revenues declined for 20 straight quarters. IBM can't shed per-unit labor costs because it's stuck with tens of thousands of legacy engineers.

It hasn't been good for the U.S. retail industry. Amazon can afford to build unlimited amounts of new warehouses and distribution space. Again, capital is free. But retailers can't possibly compete on per-unit labor costs. They've got to staff each store.

And it's not going to be good for U.S. media companies. By tying entertainment content to its "Amazon Prime" memberships, Amazon is pointing a gun directly at the head of every media/entertainment company in the U.S. Good luck competing with a $500 billion firm that doesn't have to bother with profits and has the world's best online technology.

But... is that good for our economy? What happens when investors realize, much to their chagrin, that Amazon isn't ever going to make any money? What will happen when investors realize that Amazon's core competitive advantage is that it will never make a profit?

What's the point of capitalism again?

Of course, Amazon isn't the only company that has figured this out.

If you want to see a huge, looming disaster, just watch as Netflix (NFLX) borrows billions and billions trying to compete with Amazon in media content.

Netflix charges $10 a month for its standard subscription of unlimited access to a huge media library. It has begun investing billions in producing 70 new proprietary shows. (Media is the ultimate "zero per-unit labor cost" business: It costs Netflix nothing for each additional viewer.)

Audiences love Netflix's new shows. Revenues have soared from $5 billion to $10 billion in three years. Cash flows, meanwhile, have gone from a positive number to negative $1.5 billion, annually. The company has borrowed almost $3 billion to finance this investment. After all, capital is virtually free.

But how much TV can we all watch? With almost 100 million members, how much can Netflix grow? And since capital is free and there are no per-unit labor costs to minimize, where's the barrier to competition? What will enable either business to create a sustainable advantage in the market? Talent? Both companies can easily afford to hire the world's best writers, producers, actors, and special-effects artists. It will simply be a stalemate until someone's creditor blinks. (And I'm pretty sure Netflix is going to lose...)

Meanwhile, what's the future for cable networks (charging $100 a month)?

I could show you dozens of companies whose entire business models are predicated on virtually free access to unlimited capital. Their only competitive advantage is a central bank that's lost its mind. My bet is that these firms won't last for long because the current policy is unsustainable. Why is it unsustainable? What will cause it to collapse?

My bet is commodity prices.

Take a look at the PowerShares DB Agriculture Fund (DBA).

This exchange-traded fund ("ETF") owns commodity futures. Those are contracts to deliver real-world commodities, like hogs, soybeans, cattle, and cocoa. This ETF peaked in early 2008 at $40 a share and has been in decline ever since. Farmers are great at driving down per-unit labor costs. Give them access to free capital, and supplies are going to boom – along with tractor sales.

Now, look at a chart of Deere & Co. (DE) – tractor maker to the world. You'll notice its share price has quadrupled since the financial crisis, from $27 a share to $107 a share. Farmers have bought a lot of tractors in this cycle. And commodity prices are crashing as a result.

And here's the problem...

Deere has been very effective at passing on the central banks' free money to its customers. The company now holds $24 billion in loans and leases (up from $17 billion in 2008). The company's market cap is only $34 billion. Do you think the management should be betting the company (founded in 1837) on the ability of farmers to repay $24 billion in tractor loans?

What could possibly go wrong?

Commodity prices and markets are where the central banks' policy of free money is going to crash on the rocks of reality. The real world can only consume so many soybeans... or burn so much oil. Real-world growth limits the uptake of this massive increase to capital. And it's in that transition that the financial risks lie.

I didn't even mention the oil markets.

We've written so much about oil markets over the last several years that I assume every reader knows that the glut of oil is one of the primary signs of excess in our capital markets. By my estimation, close to 30% of all the "free money" lending the U.S. central bank financed between 2010 and 2014 ended up in the oil patch. The result has been an explosion in U.S. oil production.

To summarize the resulting overcapacity that developed, look no further than the days supply of crude oil in America.

Supply almost never exceeded 30 days – ever. Supplies hadn't crossed that threshold in almost 40 years. But since crossing over 30 days supply in early 2016, days supply has barely been below that level. And we set a new all-time high supply mark in March, when that reached 34.2 days.

Keep in mind, this huge buildup in crude inventory occurred after a landmark change in U.S. law to permit the export of crude oil.

Meanwhile, despite the obvious glut, the rotary-rig count continues to grow. Every day, we're drilling more and more. Why?

Because free money also means lots of speculation. Speculators have never bet more on higher future oil prices. Historically, betting on higher prices when OPEC cuts production has been a one-way trade – a guaranteed way to make money. My bet is that this won't prove to be true this time... a result that will shock oil traders and cost them billions.

But in the meantime, producers can finance more additional production today by selling production into the futures markets to these speculators.

The futures markets, when functioning normally, help smooth out prices between peak demand seasons. But now, thanks to the central banks and the speculators they're financing, they're perpetuating an epic oil glut that will make the coming bust in oil prices even worse than in 2015... and potentially as bad as the 1930s.

Listen to this warning...

Central banks' free-money policies have led to a massive bubble in commodity production and the credit structures that have financed these huge gains. It's this commodity bubble that will blow up first and lead to the next major financial crisis.

It won't be like any other financial crisis you've ever seen.

The next financial crisis won't just hit the commercial banks. It will hit the central banks.

And there's no one to bail them out.

This is a fact...

The Swiss central bank owns more shares of Facebook than Mark Zuckerberg, the company's founder. When the world's wealthiest, most conservative, and most risk-adverse investors open a Swiss bank account to hold the world's best currency – the Swiss franc –they're really buying U.S. stocks.

In 2016 alone, the Swiss central bank ownership of global equities grew by 41%. The Swiss central bank now owns almost $500 billion worth of equities in markets around the world. That makes it one of the 10 largest investors in the entire world – a tiny country of just over 8 million people.

The U.S. stock market is approaching an all-time high level of valuation. Only the '29 bubble and the 2000 tech bubble saw the S&P 500 stock index trade at a higher multiple of earnings. (Stocks are now trading at 25 times last year's GAAP earnings.)

Stocks are now essentially more expensive than they've ever been before.

And who is buying at these levels? Central banks.

Central banks began buying stocks because they virtually ran out of bonds to buy. Said another way, once they bought so many bonds that interest rates fell to zero, they simply couldn't buy anymore. To continue their free-money policies, they had to continue to expand their balance sheets. They've done so by buying massive quantities of stocks, all around the world. For example, the Japanese central bank now owns more than 10% of every single company in the Nikkei index and is the largest owner of more than 55 different companies.

The central banks' move into equities is even more dangerous than most people realize.

You see, they've funneled their buying into indexes to minimize the costs. As a result, the majority of these tremendous inflows have been channeled into the 10 largest stocks that trade in the U.S.: Apple (AAPL), Alphabet (GOOGL), Microsoft (MSFT), Amazon, Facebook (FB), Berkshire Hathaway (BRK-A), Exxon (XOM), Johnson & Johnson (JNJ), JPMorgan (JPM), and Alibaba (BABA).

These shares are up 21% over the past year, compared with 11% for the S&P 500 as a whole.

So... the central banks aren't merely buying at the top... They're concentrating their investments and following an investment strategy that's completely mindless.

What could possibly go wrong?

The world seems to have forgotten that currencies are supposed to be unchanging units of measurements.

It's critical to a healthy economy to have a sound currency that's NOT volatile. The key to generating investment capital (which is necessary to grow productivity and wealth) is a fair playing field, where the rules and values aren't always changing.

Over the past few years, the volatility of currencies has soared. Today, Bitcoin is less volatile than the British pound. Does that sound normal to you?

The soaring volatility of currencies, along with the diminishing volatility of the world's stock markets, is a direct result of the central banks' equity buying. As long as the central banks supply a never-ending "bid" for stocks and continue to stuff their balance sheets full of financial securities, the world's traders are going to treat their currencies like stock index funds – because that's what they've become.

Central banks' free-money policies have now permanently linked the value of every currency in the world to value of the stock market.

As a result, governments have turned the global economy and the value of every currency in the world into ticking time bombs.

The next panic in the stock market won't merely hurt stock investors.

The next panic will hurt every human being on the planet... because every currency in the world is now tied to stock and bond prices.

Next week, I'm going to talk about the social impacts of these policies. The central banks haven't merely wrecked the world's currencies... They've warped our political systems, too. Although it's probably hard to believe, these changes are the most dangerous aspects of what's happening right now.

But... I don't want today's Digest to be completely theoretical...

These big, macro themes have important, near-term implications...

The most critical to understand right now is how the free-money policies have led to a huge bubble in corporate credit.

A virtual tidal wave of corporate debt is coming due over the next three years.

This pile of debt is lower-rated overall and contains more "junk" issuance than any other corporate debt cycle in history. When I talk about how commodity prices and the credit structures that surround commodity production are the weak link in the central bankers free-money policies... I'm talking about the coming huge defaults in corporate credit.

With default rates already hitting 5%, it seems clear to most corporate-debt analysts that this default cycle is going to be a "doozy," with losses for investors approaching 40% of junk issuance, at least.

That's $1.5 trillion to $2 trillion in potential losses in the next four years.

I wrote a new warning about these problems last week. I hope you took the time to read that carefully. And, then this week, my colleague and DailyWealth analyst Brett Eversole wrote about the same topic.

However, Brett looks at the markets from a completely different perspective. My work is "bottom up." I'm looking at the detailed fundamentals of each issuer and each type of debt that's outstanding. Our corporate-credit database includes information on more than 40,000 individual credits.

Brett, on the other hand, looks at the dynamics of the entire market, not individual issuers. What he sees is that credit spreads (the premium investors earn to hold risky debt) are far too low for this stage of the credit cycle. His advice is to sell all of your high-yield bonds, right now. If you haven't seen his work, I'd recommend looking at it closely.

If you've been reading our Stansberry's Credit Opportunities newsletter...

You know that we've been writing about these risks to bond investors for months. Looking at the corporate-credit market at the individual-issuer level, we've watched all of the good opportunities disappear.

The following chart shows you the percentage of distressed, high-yield bonds that are trading at significant discounts. The dark blue bars indicate what percentage of the market is trading at a deeply discounted price (below 50% of par) and the light blue shows you the percentage trading at a substantial discount (a 20%-50% discount).

In the first few months after we launched our Credit Opportunities newsletter, around 11% of the market was trading at a substantial discount or more. Today, it's just 1%.

That's why in our Stansberry Portfolio Solutions' Total Portfolio (where we built a complete portfolio of 40-plus positions to demonstrate our best ideas and ideal asset allocation) we only have 10% of the portfolio allocated to distressed corporate debt.

We'd prefer to have a 50% allocation to these kinds of investment opportunities. (Yes, that's right, a 50% allocation to distressed corporate debt. As I've written for years, if most investors understood how much money they can earn – safely – in distressed corporate debt, they'd never buy a stock again.)

So, is today a great time to buy distressed corporate debt? No, absolutely not. Does that mean the strategy doesn't ever work? No, absolutely not.

Our job as investment analysts is to stand at the plate and look at the pitches. We can't control what the pitcher throws. We can only decide when we're going to swing. But the cool part of this game is that there are no "called" strikes. There's no penalty for not swinging. That ability, to sit tight, hold cash, and ignore everything except for the "fat pitch" right over the plate is something that most investors never learn. But I hope you will.

One last point about all of this...

You can bet that at some point in the next four years, the risk spread on junk bonds will "blow out" again to 10% or more. When that happens, we'll start pounding the table on buying carefully selected distressed corporate credit. These bonds will be trading for $0.80 on the dollar (or less) and yielding 15% a year or more. These are great investments that can provide unbelievable returns, with almost no risk.

We made a slew of these recommendations during the 2009 to 2010 default cycle. We did it in 2015 and 2016, when defaults first spiked off their cyclical lows too. I'm 100% certain we'll be there for our subscribers when it's time to put capital to work in this asset class. Until then, we've just got to keep watching the pitches.

(By the way, if you've invested using our advice in the distressed corporate-credit markets and you've seen how big the profits can be when you buy at the right point in the cycle, please send us a note. We want to encourage as many subscribers as we can to get involved in this kind of investing. As I've always said, most investors shouldn't ever buy stocks at all. Most investors would greatly increase their average returns by limiting themselves to only investing in corporate bonds. If you've come to understand why I say that so often, please send us a note that we can share with other investors here: feedback@stansberryresearch.com. As always, we're happy to withhold your name.)

I hope you enjoyed today's Digest. And again, if you know anyone you think would enjoy reading about the potential downside of today's dominant economic policies, please free to forward this along.

New 52-week highs (as of 4/20/17): Tencent Holdings (0700.HK), Alibaba (BABA), Becton Dickinson (BDX), Chipotle Mexican Grill (CMG), Quest Diagnostics (DGX), Digital Realty Trust (DLR), Facebook (FB), Cedar Fair (FUN), JD.com (JD), KraneShares CSI China Internet Fund (KWEB), McDonald's (MCD), Naspers (NPSNY), Shopify (SHOP), iShares MSCI India Small-Cap Fund (SMIN), and Tencent Holdings (TCEHY).

In today's mailbag, several folks weigh in on reader Joe N.'s "sour grapes." Send your notes to feedback@stansberryresearch.com.

"Great response to Joe N. True wealth comes as a result of (many) trials and tribulations (and learning from those). Too often people think that money solves problems, or makes you a better person, somehow. It's a reaction from a survival- (and victim-) based consciousness. No one can limit you, but you. Cheers." – Paid-up subscriber Angelo C.

"Loved your reply to Joe N. I'm sorry to say that some people will just never be able to look beyond those dollar signs. Your reply was calm, caring, and classy. Thanks for showing us a graceful way to respond to envy and jealousy." – Paid-up subscriber Steven C.

"PORTER you wrote, 'We've all long since figured out the snobs are just folks who can't actually afford their lifestyle. The guys who can don't care to show it.' So true... If what you wrote is not a universal truth, it should be.

"I learned that over 20 years ago when I had my business. Nobody ever knew I was the owner. I was just the guy that was always there cleaning up, keeping everything working, and taking care of my customers. And it was the ones who couldn't 'actually afford their lifestyle' that always looked down their noses at me and were always asking me for free extra time on the machines. They were the ones I learned to avoid when I would see them come in. Thank you." – Paid-up subscriber Neil Silver

"Joe N's response is all too common in this country. What brought my mother to this country and my paternal great grandparents to this country from Ireland was the opportunity to prosper. None of us are multimillionaires, but we have prospered. A large majority of the multimillionaires that I play golf with are definitely not snobs. I actually miss reading and seeing pictures of your Atlas 400 trips that you used to share. My favorites were of the trips to Germany for racing Porsches and BMW's. Work, save, invest, and enjoy your life. Keep up the great job." – Paid-up subscriber K.M. Kelly

"Some people are so caught up in their own needs that aren't being satisfied that they dump on anything that smells of success. And I don't believe the Atlas 400 is primarily for everyone to recognize that success, even though it's self evident. The writer of the letter seemed to think so.

"I once responded to an article about Martha Stewart. In the response letters to the article, almost everyone spoke ill of her and her capabilities. So I finally had to say something. We have a motorhome whose interior was designed by Martha, and it's the most outstanding combination of not only colors but textures and woods. Not content with just making everything 'fit' she even had diamond shaped inlays in the border woods to reflect the ones in the fabrics and wallpaper. Subtle, but absolutely stunning. In fact, it was her interior that sold the coach.

"And what did other responders have to say of my input? Tut, tut, we have a motorhome. Big deal. Snob. So the world is full of jerks, and they have no other place to aim their hatred. I'm surprised he's a paid member. We usually have more class." – Paid-up subscriber Robert Faulks

Regards,

Porter Stansberry
Baltimore, Maryland
April 21, 2017