This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on Nov 23 - 29, 2015.

WE ARE nearing the end of this particular benign cycle of cheap credit, high liquidity and low default rates. While cheap capital is still available, Professor Edward Altman advises investors not to avail themselves of it but to reduce exposure and have the courage to stand by their conviction that winter may be coming and it is time to prepare. 

The time of low default rates and high liquidity is almost at an end. We are heading towards the end of this particular “benign” cycle, and there are already signs of a credit bubble building and an increase in defaults, especially among commodity companies.

Professor Edward Altman, world authority on risky debt markets and Max L Heine Professor of Finance at New York University’s Stern School of Business, believes investors should reduce their exposure to the fallout, and to the extent they can, hedge it.

“Hedging is expensive if everyone believes there will be a crisis, but not everyone believes it yet. But increasingly, they do. So, go short credit — which means, buy ETFs (exchange-traded funds), go short on the stock market or go short interest rates,” he says.

“The easiest thing to do is just reduce your exposure to credit risk in anticipation of that. But that takes courage in a low interest rate environment, and you need to have the courage of your conviction. Don’t take a loan, especially if there’s a risk that you’ll lose your job or your pay will go down.”

Are there any safe havens left? Where should investors put their money? “Under your pillow,” he quips, only half facetiously.

Altman uses baseball to draw an analogy of the present economic situation. “Baseball has nine innings. At the end of the ninth inning, the game is over, and whichever team is ahead wins the game. But if the score is tied at the end of the ninth inning, we have extra time.

“The reason I bring up that metaphor is the fact that the benign credit cycle that we are in — low default rates, low interest rates, high liquidity — has lasted almost six years starting in 2010. The longest it has ever lasted before is seven years. That means normally, if this continues, the end of the cycle is likely to be the end of next year. And then the defaults should increase, interest rates should rise, required rates of return should increase and we should have another crisis.”

But this assumes that the central bank does not intervene, as it has up to now. “One of the reasons why we have had all these low interest rates and low default rates is the artificially low interest rates manufactured by the central bank. And by the way, the Federal Reserve is not the only central bank to do this. The US started it, but the European Central Bank picked up the theme and it is also trying to manufacture growth by stimulating debt, and one way to do that is to lower interest rates,” says Altman.

This could be dangerous, he adds. “As we found in the Asian financial crisis of 1997/98, the countries that manufactured the most growth were the ones that had the most debt, led by South Korea and followed by Thailand and Indonesia. One of the reasons Malaysia didn’t suffer as much is the fact that the growth was not stimulated as much by debt.”

But the times have grown precarious and it would be worthwhile to watch out. World Economics chief executive Ed Jones, commenting on the Sales Managers’ Index coming out of the US for November, says the index indicates a sharp slowdown in the growth of the US economy in the fourth quarter of this year to around 1%. Business confidence is now at a two-year low, he adds.

Altman is on a lecture tour around the world. He stopped in Kuala Lumpur briefly to speak on “Managing Corporate and Sovereign Credit Risk in a Global Environment” at a seminar organised by RAM Holdings Bhd before flying off to Australia. His main message was the growing bubble in credit markets. 

“This is not necessarily a Malaysian situation,” Altman hastens to say. “But it could impact Malaysia. If we have a meltdown, another crisis in credit, it will affect global markets, just like it did in 2008/09.”

The signs are already there. “The bubble is building, based on the large amounts of debt that have been issued by companies in the last five years, supposedly taking advantage of low interest rates. And the quality of that debt has been increasingly very risky, which probably means higher default rates in the future. And default rates are my definition of a bubble building,” he states categorically.

These defaults, says Altman, are led by the oil and gas as well as mining companies — the first to see the fallout from the situation. “For the first time since 2009, we are seeing an increase in default rates, mainly coming from the oil and gas and mining companies.”

These companies raised enormous amounts of debt financing a few years ago to pay for what they thought would be necessary capital for growth. But these assumptions were made when oil was selling for US$80 to US$100 per barrel.

“Now at US$43 to US$44 per barrel, the operation is not sustainable and already we are seeing a large number of companies defaulting on their debt, going bankrupt, or both. And it is only going to get worse before it gets better, meaning that I think the number of these companies that default will accelerate,” says Altman.

The carnage in the commodities market, brought about by decreased demand from China, is already apparent among the big names. Royal Dutch Shell plc announced it would abandon its drilling campaign in the US Arctic waters after spending US$7 billion (RM30.7 billion). Alcoa Inc, the biggest US aluminium producer, said it would break itself into two companies, separating its manufacturing operations from a legacy smelting and refining business. And more recently, Swiss-based commodities powerhouse Glencore plc saw its stock lose almost one-third of its value in a single day of London trading. Why? Because commodity prices are too low, the company’s debt is too high and demand from China has cooled off.

As an indication, iron ore prices plunged from US$180 per tonne in 2011/12 to US$65 per tonne at end-2014. Citigroup predicts that it will fall to US$40 per tonne in the first quarter of next year. Crude oil prices went from US$20 per barrel in the early 1990s to a peak of US$180 per barrel and has fallen to around US$40.

The bubble is there, but Altman does not think it will burst, necessarily, unless there is an economic recession in the US and/or China. “I don’t see that happening within two years. After that, it is anybody’s guess.”

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.