Walking dead: The zombies may finally be killed off

There has been a lull in bankruptcy volumes globally during the pandemic because of the relief measures and the deluge of near-costless liquidity pumped into the global financial system by the central banks, which has underwritten cash flows for vulnerable companies.

It has also, however, increased those companies’ indebtedness within a global system that is now significantly more leveraged.

If the central banks are forced to engineer a recession to bring four decades-high inflation rates under control, the number of zombies could rise quite dramatically.

Global debt last year reached a record $US303 trillion, according to the Institute of International Finance, or $US77 trillion more than in 2020 and the biggest one-year increase since World War II. Investment manager Janus Henderson has predicted a not dissimilar increase – about $US72 trillion – this year.

If that access to cheap debt kept some companies afloat through the pandemic then the increase in interest and debt-servicing costs and the decrease in central bank-provided liquidity now occurring is threatening to sink them.

Over time research by both the BIS and OECD has shown the proportions of zombie companies in listed company markets has been increasing.

Between the late 1980s and 2017 it had risen from about 4 per cent of listed companies in the OECD to about 12 per cent. In Australia the proportion has been estimated, pre-pandemic, at about 12 per cent (some estimates are much higher) and in the US about 16 per cent.

It would seem reasonable to assume that, after the traumas of the pandemic and with the fiscal and monetary spigots now being tightened, the numbers of zombies will rise. If the central banks are forced to engineer a recession to bring four decades-high inflation rates under control, they could rise quite dramatically.

The historically cheap debt and equity environment that has prevailed since the financial crisis has helped keep borderline companies afloat and fuelled the rise in the “unicorns” ($US1 billion-plus tech companies) along with a host of other tech and industrial companies whose values have been underwritten more by expectations of eventual profits than by actual earnings.

Equity markets are now tumbling and the cost of servicing debt – debt that has increased quite significantly before and during the pandemic – is blowing out. High-yield, or junk bond, spreads in the US are now 400 basis points above risk-free rates that have themselves risen steeply.

The nadir of the 10-year bond rate in the US was 57 basis points in August 2020. It’s now about 2.8 per cent, having hit 3.13 per cent earlier this month. In Australia the 10-year rate was below 70 basis points at the onset of the pandemic and is now about 3.3 per cent.

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The rising interest rates and debt-servicing costs and tumbling equity prices (and reduced access to equity for companies with weak cash generation) are a tide going out; arguably the first time the tide has really turned since 2008.

As Warren Buffett famously said: “Only when the tide goes out do you discover who’s been swimming naked.”

There are some “ifs” here. Confronted by the prospect of recessions will central bankers and governments hold their nerves and prioritise the need to bring inflation under control over company collapses, rising unemployment and further blow-outs in already historically high public debt and deficit burdens?

If they do, then zombie companies that were only alive pre-pandemic, and some the pandemic created, will be exposed and, to some degree at least, economies will be purged of their weakest enterprises.

That would not necessarily be a bad thing for the wider economies.

The “whatever it takes” approach of central banks and governments post-2008 has locked up a lot of valuable capital in unproductive and purely speculative activities.

They have muffled pricing for risk and frustrated the forces of “creative destruction” that enable financial and human capital to be recycled and used more productively and may be part of the explanation for why productivity in the major economies has been flat-lining since the financial crisis.

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If central banks remain committed to fighting inflation and governments to reducing their pandemic-swollen leverage the tide will go out for a lot of zombie companies and activities and being exposed for swimming naked will be the least of their concerns.

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