Zombie Firms

January 19, 2024

To start off the year let's look back at the Federal Funds Rate since 1950:

There are a few things to observe. The time period from 2008 to 2020 was unusual, with almost 10 years of free money in that window. Then, starting in 2021, we have a steep wall up, bringing us back to an area that resembles the long-term average.

Average in this case sounds good. And perhaps the economy can absorb the slope of the wall up. The issue is the ten years of free money before the reset, and how that is going to reflect on this year and the next couple of years.

When the cost of capital becomes free, bad decisions creep into businesses. The process happens gradually at first, when that sprightly investment banker shows up and makes a pitch to corporate management:

"Look, running a public company is hell. It's a regulatory nightmare, you have to watch every word you say, lawsuits are commonplace, you're hooked to quarterly earnings reports. You'll probably either quit or be fired in five years, so let us apply some financial engineering to this otherwise very mediocre firm and juice [list several financial ratios here], and hence the stock price."

And after a few whiskey sours the CFO decides this isn't such a bad idea and so eventually it happens. The market problem is that the firm's competitors then start falling behind. So pretty soon they have the bankers on speed-dial also looking for some low-cost juice.

And you end up with lots of debt in lots of average firms. These are called zombie firms, and it's like a capitalist version of The Walking Dead. The term, defined by the Bank for International Settlements, refers to firms that have not earned enough profit over the past three years to even cover their interest payments.¹ At the turn of the millenium, about 2% of firms were Zombie firms. *Before* the interest rate wall in 2020, almost 20% were. If you cut the time period from three years to one, almost 30% of firms may land in the category today.²

Zombie firms distort the allocation of capital, and they drive inflation by funding projects and hiring for roles that make little economic sense. This creates a headwind for their competitors. Unique in American history, this headwind went on for a long time in 2008 - 2012, giving significant advantage to the zombies.

The cheap money party is over, and a major investing story in 2024 and 2025 will center on how this unwinds. One would think that with debt resetting and interest rates higher the scenario is bleak. But The Wall Street Journal is reporting today that the market for subprime debt remains strong. If the banking system stays healthy and the economy roars forward, this may be an orderly transition. If the economy turns down, the shockwave will be stronger.

But it's not necessarily a zombie apocalypse for an index tracking a large basket of stocks, because even if zombie firms do collapse into bankruptcy or scale back significantly, their competitors with lower leverage ratios may benefit.

Dan Cunningham

1. Keep in mind earnings numbers are relatively easy to manipulate.
2. Source: Deutsche Bank Research