After the flood – Beyond fiscal and monetary intervention

After the flood – Beyond fiscal and monetary intervention

in-the-long-run-small-colour-logo

Macro Letter – No 130 – 26-06-2020

After the flood – Beyond fiscal and monetary intervention

  • Monetary and fiscal stimulus to ameliorate the effect of the pandemic has exceeded $9trln
  • Stock markets have recovered, although most are below their February highs
  • The combined supply and demand shock of Covid-19 is structural
  • A value-based investment approach is critical to navigate the transition

In my last Macro Letter – A Brave New World for Value Investing – I anticipated the beginning of a new phase for equity investment. In this Letter I look at the existing business and economic trends which have been accelerated by the pandemic, together with the new trends ignited by this sea-change in human behaviour.

In economic terms, the Covid pandemic began with a supply-shock in China as they were forced to lockdown the Wuhan region. This exacerbated strains which had already become evident in trade negotiations between China and the US, but also revealed weaknesses in the global supply chains. A kind of ‘Mexican Wave’ has followed, with a variant on the initial supply-shock occurring in successive countries as the virus spreads from region to region and governments responded with lockdowns.

The supply-shock has gone hand in hand with a global demand-shock. The key difference between this recession and previous crises is the degree to which it has impacted the service sector. According to 2017 data, the service sector represents 65% of global GDP, whilst Industrial/Manufacturing accounts for 25%, Agriculture represents only 3.43%. Over time, Agriculture and Manufacturing has become more increasingly automated, the principle growth sector for employment is Services. The ILO Monitor: COVID-19 and the world of work. Fourth edition states:  –

As at 17 May 2020, 20 per cent of the world’s workers lived in countries with required workplace closures for all but essential workers. An additional 69 per cent lived in countries with required workplace closures for some sectors or categories of workers, and a further 5 per cent lived in countries with recommended workplace closures.

The latest ILO estimate for Q2, 2020 indicates a 10.7% decline in working hours – equivalent to 305mln lost jobs worldwide. 60% of these job losses have been in four industries, leisure, retail, education and, perhaps counter-intuitively, healthcare. The knock-on effects have been felt almost everywhere.

Governments and central banks have responded. The chart below shows the rapid expansion in central bank balance sheets: –

CB Balance Sheets - Yardeni

Source: Yardeni, Haver Analytics

The Federal Reserve began their latest round of quantitative easing in August 2019, well before the onset of the pandemic. They have added $3.3tlrn in nine months, seeing their balance sheet balloon to $7.1trln.

Around the world, governments have also reacted with vigour; on May 20th the IMF updated their estimate of the global fiscal response to $9trln, of which $8trln has emanated from G20 countries. The geographic breakdown as a percentage of GDP can be seen in the table below: –

REVISED-fiscal-firepower-eng-may-11-image-fm-chap-1-chart-2-2-600x757

Source: IMF

The majority of global stimulus has come from the richer developed nations. Assuming this pattern continues, emerging market equities are likely to lag. The table below ranks a selection of emerging economies by four measures of financial strength, public debt, foreign debt, cost of borrowing and reserve cover: –

20200502_BBC380

Source: The Economist, IMF, JP Morgan, iShares

Overall, whilst the flood may subside, global expenditure should continue to rise as the pandemic sweeps on across the globe. Whilst loan forbearance and forgiveness, together with state guarantees, will help to maintain the solvency of many existing corporations, new spending will be aimed at stimulating employment. Infrastructure projects will be legion.

Impact on Industry Sectors

For investors, the abrupt changes in supply and demand, combined with the impact of the fiscal and monetary response, make navigating today’s stock markets especially challenging. To begin, here is a chart from 2019 showing a breakdown of industry sectors in the US by their contribution to GDP: –

Deloitte Fig 1 (1)

Source: Deloitte, BEA, Haver Analytics

This tells us that finance, insurance and real estate are the largest sector but it fails to tell us which sectors are thriving and which are not: –

Deloitte Fig 2 (1)

Source: Deloitte, BEA, Haver Analytics

Here we see the continued march of digital transformation, but also the ever increasing share of healthcare services in GDP; near to four decades of asset price appreciation has created an asset rich aging cohort in developed economies which, if not healthier then definitely wealthier. Looking ahead, developed nations are better equipped to weather the crisis better than their developing nation peers. Within developed nations, however, smaller businesses, especially those which cannot access capital markets, will fail, whilst larger firms will fare far better. Private Equity funds will also find rich pickings among the plethora of distressed private market opportunities.

Since the outbreak of Covid-19, several trends have accelerated, others have been truncated or reversed. Social behaviour has had a negative impact on travel, leisure and retail. Declining demand for travel has damaged a range of industries including airlines, autos, oil and gas. The leisure sector has been hit even harder with hotels, restaurants and bars closed, in many cases forever. The sports industry has been severely undermined. Meanwhile the decline in retail has accelerated into a downward spiral.

Nonetheless, several industries have benefitted. Within retail, online sales have hit new records, grocery sales have ballooned. Healthcare has gone digital, from consulting to dispensing productivity gains have been evident. The home improvements industry has benefitted even as commercial real estate has suffered. Working from home will be a permanent feature for many office workers. Every existing home owner will need to create a permanent office space, every new home buyer will need more space to incorporate an office. Longer, occasional, commutes will lead people to move further from the city. Some workers will move to more clement climes, requiring less energy. Structural changes in where we live and how we live present threats and opportunities in equal measure. For example, every house will require better communications infrastructure, high speed connectivity and broad, broadband will become the norm.

Changes in the delivery of goods (direct to homes rather than to retail outlets) means more inventory will held in out-of-town locations. Inner city retail and commercial property businesses will consolidate as out-of-town commercial thrives. New out-of-town property demand will also emerge from the manufacturing sector. The on-shoring of production was already in train, with robots replacing cheap labour from developing countries, now, concern about the robustness of supply chains, especially for critical manufactures such as pharmaceuticals, will encourage a wave of old industries in developing countries to be reborn. Whereas in retail, larger inventory may become more prevalent, in manufacturing, ‘just-in-time’ delivery and lower transportation costs will compensate for higher fixed production costs.

The energy sector has suffered a medium-term setback, for example, 28% of all US gasoline is consumed in the daily commute. After the lockdown, some commuters will choose to travel alone rather than by public transport, many more will now work permanently from home. Yet whilst gasoline demand falls, demand for diesel, to fuel the home delivery revolution, will rise. Home heating (and cooling) is also set to rise and, with it, demand for heating oil and natural gas. Overall demand may be lower but there will be many investment opportunities.

In healthcare, aside from tele-medicine, which is forecast to capture between one third and half of consultation demand, there is also increased appetite for bio-sensors to measure multiple aspects of health. Hospital consolidation will continue in an attempt to drive efficiency. On-shoring of drug manufacture may well be mandated, online delivery is likely to become the new normal, especially to the elderly and infirm who are advised to shelter-in-place. On-shoring creates domestic jobs, government favour will focus on these companies.

Airlines will be forced to diversify or merge; I envisage a mixture of both strategies. A diversification into car hire, travel insurance and hotels seems likely. Many airlines are national carriers, they possess an implicit government guarantee, their financing costs will remain lower, their low-budget competitors will diminish, fare discounts will become fewer and, thereby, their fortunes may conceivably rebound.

The automobile industry remains in a state of turmoil, but new technology will continue to determine its fortune. If de-urbanisation continues, whilst commuting will decline, there will be an increased demand for individual car ownership, especially electric vehicles. In the fullness of time, the industry will transform again with the adoption of driverless transportation.

Technology will, of course, be ubiquitous. The fortunes of the cybersecurity sector have been ascendant since the crisis began, but even relatively ‘non-tech’ businesses will benefit. Commercial real estate will gain as tech firms seek out ever larger data centres to support their cloud computing needs. The auto industry will benefit from improvements in battery storage and charging times. This will also change the economics of electricity for homes and factories. Green energy will come of age.

Tourism will recover, the human race has not lost the desire to travel. In Europe tourism is down between 30% and 40% – it accounts for 10% of GDP. The rebound will be gradual but the travellers will return. More consumers will buy on-line.

Banking and finance will evolve to meet the challenges and needs of the industrial and services sector. Certain trends will continue, bricks and mortar will give way to on-line solutions, branch networks will consolidate. With government support, or threat, existing loans will be extended, new loans made. As household savings rise, new credit will be granted to new and existing entities, few questions will be asked.

Insurance companies will consolidate, once claims are paid, premiums will rise and competition lessened. As with banking more consumers will move on-line.

Employment

Looking beyond the business potential of different industry sectors and the technological advances which will support them, we should remember that governments around the globe will direct fiscal policy to alleviate unemployment, the initial flood of fiscal aid may moderate but if the tide goes out the ebb will be gradual, this is one of the benefits of a fiat currency system. According to the ILO, in 2019, employment in services accounted for 50%, Industry 23% and Agriculture 27%. The chart below shows how employment by sector has evolved over the last 28 years: –

Global Employment by Sector – Services – Agriculture - Industry (1)

Source: World Bank, ILO

The services sector has embraced employees leaving agriculture, whilst industry has grown without significant employment growth. The leisure industry, including hotels, restaurants and bars, is one of the largest employers of low-skilled, part-time employment. Consolidation within the hotels sector is inevitable. Larger, better capitalised groups will benefit as smaller enterprises fail. Corporations from beyond the leisure sector will diversify and private equity will fill the gaps which public companies step aside.

Conclusions and Investment Opportunities

In my previous Macro Letter I concluded that value-based analysis would be the best approach to equity investment. On closer examination, one can find risk and opportunity in almost every industry sector. In the last three month, stock markets have risen, but stock return dispersion remains heightened. A prudent, value-oriented, framework should yield the best results in the next few years.

A Brave New World for Value Investing

A Brave New World for Value Investing

In the Long Run - small colour logo

Macro Letter – No 129 – 05-06-2020

A Brave New World for Value Investing

  • Stock markets have rebounded from their March lows on fiscal and monetary stimulus
  • Corporate bond spreads have narrowed in their wake
  • The prospect of further fiscal spending and broader quantitative easing remains
  • The global economy has changed forever and value analysis is back in demand

Perhaps the most frequently used adjective during the Covid pandemic is ‘unprecedented.’ On the 14th February, when I published – Macro Letter – No 126 – 14-02-2020 – When the facts change – I wrote: –

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Much has happened since, yet, in my conclusion, I stated: –

…the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy.

… Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

To judge by the current level of the Nasdaq 100 (current level 9,683 as at COB 03-06-2020, just 1.6% below its all-time high) the unprecedented crisis has been met by an equally unprecedented policy response. The S&P 500 has lagged the Nasdaq somewhat and the MSCI World Index still more: –

Nasdaq 100 v SPX v MSCI - Yahoo Finance (1)

Source: Yahoo Finance

Returning to my letter from February, the facts have changed, governments and central bankers have responded to a crisis, a crisis which proved far worse than anticipated. The stock market collapsed, but has now regained composure, nevertheless, the main driver of stock market performance for more than a decade – ability of central banks to lower interest rates – has been exhausted. The central bankers’ armoury is not quiet empty, however, they still have the QE bazooka which can be aimed at corporate bonds and even common stocks, but, not wishing to exceed their mandates they have turned to their respective governments’ for guidance and succour.

Governments’ can and have responded to the pandemic in a manner which is both broader and more direct in its impact on the economy and businesses. Going forward the effect of government largesse will be felt in a less consistent manner than the largesse of central banks. For governments’ employment will take precedence over corporate profits, corporate executives would be wise to recognise the profound change in the terms of engagement. Stock performance can no longer be assured by increasing debt to repurchase stock. Mergers which rely on rationalisation will be thwarted from above. Wages are unlikely to rise given the increase in unemployment, but the cost of making incumbent employees redundant will have adverse consequences both seen and unseen. Firms that hire will find favour, those that trim payrolls will not.

We will witness the return of the Value Investor, an endangered species who underperformed the Index Trackers during the decade since the great financial crisis. The great rotation away from index tracking or hugging is about to begin. Technology will continue to provide new employment opportunities even as more roles in the wider economy become automated. The public sector will create opportunities. Infrastructure spending is set to bring a ‘New, new deal’ to those in need of work. Healthcare will continue to expand as the population of developed countries age and life expectancy increases.

Other changes are also afoot. Working from home is about to become the norm for many people. Video conferencing, now widely adopted, brings into question the need for excessive travel. Demand for office space is already in retreat. Many firms are reporting unexpected productivity gains from the enforced ‘work from home edict,’ and have cancelled leases in favour of smaller, more flexible office space. Meanwhile, those eponymous start-ups, for whom flexible office space was the norm, have made a virtue of necessity, slowing their cash-burn – and mollifying investors in the process – by closing their offices altogether.

As economies recover from the effects of the lockdown, companies will fall into three categories based on their prospects for recovery from the dual supply and demand shock – ‘L,’ ‘U’ and ‘V’. The Tech giants (V) have rebounded and their prospects remain strong, even at these exalted valuations. Investment Grade Corporates (U) will take longer to recover, but even before interest rates were lowered by the Federal Reserve (Fed) these corporations were preparing for an economic slowdown. Q1 corporate debt issuance surged to the highest since records began in 1980: –

1-US-debt-issuance-20-05-2020 refinitiv

Source: Refinitiv

The High-Yield bond market followed in the wake of Investment Grade issuers, although the sudden widening of credit spreads in March dampened their ardour. Issuance returned with renewed urgency as soon the Federal Reserve announced that ‘Junk bonds’ where to be included in its expanded asset purchase program: –

2-US-debt-issuance-20-05-2020

Source: Refinitiv

This chart from the St Louis Fed tracks yield changes year-to-date for the High Yield bond index: –

fredgraph (1) HY YTD

Source: Ice Data Indices, Federal Reserve

High yield bond yields remain elevated despite the interest rate cuts and Fed asset purchase promises. On 3rd June they averaged 5.8% up from 3.56% in mid-February, but far below their 23rd March high of 10.87%.

Many of the firms in the high yield sector (L) are involved in the Oil and Gas industry. As oil and gas prices rebound, they will regain some composure and, being high profile employers, they should receive government support. Other firms may fare less well, these are those destined to follow an ‘L-shaped’ recovery. Their survival will be dependent on their ability to provide employment, some will be saved, others will fail.

Conclusion

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

In the Long Run - small colour logo

Macro Letter – No 127 – 13-03-2020

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

  • As the COVID-19 pandemic gathers momentum, history offers too few data points
  • The Spanish Flu is the nearest comparison – similarities are matched by differences
  • Clinical trials have started, but the rise in new cases is slowing in China already
  • Global economic growth will suffer, but monetary and fiscal stimulus should support stocks

As I write this article I am conscious that the Coronavirus is a very real and global tragedy. In all that follows I do not wish to detract from the dreadful human cost of this disaster in any way.

Putting the current pandemic in perspective, according to a 2017 estimate from the US Center for Disease Control, in a normal year, seasonal flu kills 291,000 to 646,000 globally. By contrast, the fatality rate for coronavirus seems to have stabilised at around 3.6% of those diagnosed. Of course, a more heartening figure of 0.79% can be found in South Korea which has tested almost 10 times more of its population than other country:-

Testing for COVID-19 - 9-3-2020 - Worldometer.com

Source: Worldometer.com

Suffice to say the current statistics are still confusing at best, but they are all we have to work with.

In a recent interview Dr Soumaya Swaminathan of the World Health Organisation (WHO) provided some insights (emphasis is mine): –

Of 44,000 Wuhan patients 80% had very mild symptoms, 15% of cases are severe and 5% critical. In terms of transmission rates, the R0 is still just an estimate of between 2 and 3 – in other words for every carrier between two and three people are infected.

…Two drugs, an antiretroviral called Lopinavir-ritonavir and an experimental drug used in the treatment of Ebola – Remdesivir, manufactured by Gilead (GILD) – are being tested in China where more than 80 clinical trials are already underway. The development of an effective vaccine it several months away. 

It was reported today (11-3-2020) that Gilead has begun trails with US nationals and signed a deal with the US military.

Market Impact

Given the continued lack of clarity about COVID-19 in terms of numbers infected and numbers suffering, it may seem futile to attempt to gauge the potential economic impact of the current Coronavirus outbreak. History, however, may be able to provide some guidance to investors who might otherwise be tempted to liquidate and hibernate, especially after the dramatic decline this week in the wake of Saudi Arabia’s decision to turn its back on the OPEC cartel.

In order to begin this assessment, there are a vast array of factors which need to be considered. Here are just a few: –

  1. Speed of spread – higher in urban areas due to population density
  2. Urban versus rural population – generally a function of GDP per capita
  3. Likelihood of a cure or vaccine – the majority of estimates range from three months to a year (hopefully it was be sooner)
  4. Health of demographic cohorts by country – a function of average age and GDP per capita
  5. Average income – also a function of GDP per capita
  6. Extent of healthcare coverage – generally a function of GDP (although European welfare arrangements are more developed than those of the US)

Each of these factors are complex and warrant an essay to themselves. Suffice to say, the economic impact is already becoming evident. Schools, factories and offices are closing. Those workers that can are beginning to work remotely. At the extreme, entire cities, towns and countries are being subjected to lock-downs. In these conditions, economic activity inevitably suffers, this is a supply and demand shock combined. The price of crude oil has already responded, encouraged by the actions of Saudi Arabia, it has collapsed. Transportation activity has been substantially reduced. Economic indicators from China point to a pronounced contraction in 2020 GDP growth. Will the pattern seen in China be repeated elsewhere? Are the nascent indications of a resumption of economic activity now evident in China a reliable indication of the speed of recovery to be expected elsewhere? The jury is still out.

For G20 countries the effect of the 2008/2009 financial crisis still lingers. According to a BIS report more than 12% of developed nation firms generate too little income to cover their interest payments. Meanwhile, at the individual level, the Federal Reserve estimates that more than 10% of American adults would be unable to meet a $400 unexpected expense, equivalent to around two days’ work at average earnings. There is concern among governments that people may start to hoard cash if the crisis deepens.

Where the viral epidemic began, in China, the Purchasing Managers Index for February was the lowest since the series began in 2004. According to China Beige Book’s flash survey for February, 31% of companies were still closed and many of those that have reopened lacked staff or materials. Other estimates suggest that between 40% and 50% of the China’s truck fleet remains idle – those essential materials are unlikely to be delivered anytime soon. This supply-shock slowdown has inevitably fuelled expectations of an actual contraction in the size of the Chinese economy, the first shrinkage since the death of Mao Zedong in 1976: –

China PMI

Source: Trading Economics

Everywhere GDP forecasts are being revised lower: –

Economist GDP revisions from Q4 2019 to Q1 2020 OECD

Source: Economist

Policy Response

For the world’s governments there are essentially three policy responses: –

  1. Provision of credit via banks and money markets – central banks are doing what they can
  2. Aid to corporates to meet fixed costs, such as rent and tax bills
  3. Protection of workers by subsidising wage costs

Central banks are limited in their ability to lend directly to firms, meanwhile the banking system, petrified by the recent widening of credit spreads for sub-investment grade debt, is likely to become a bottleneck. It will take more than gentle persuasion to force banks to lend new funds and reschedule existing non-performing loans. Other aid to corporates and individuals requires varying degrees of fiscal stimulus. Governments need to act quickly (today’s UK budget is an indication of the largesse to follow) it would also help if there were a coordinated global policy response.

The Peterson Institute – Designing an effective US policy response to coronavirus make the following suggestions: –

A first step is to lock in adequate public funding. In 2014, emergency funding of about $5.4 billion was provided to fight the Ebola outbreak. Much more than that should be provided today, given the apparently greater transmissibility of COVID-19 and the fact that it has already appeared in many locations around the United States and more than 60 countries around the globe.

…A classic recession involves a shortfall of demand relative to supply. In that more ordinary situation, economic policymakers know how to help fill in the missing demand. But this case is more complicated because it involves negative hits to both supply and demand.

No one knows how serious the economic damage from COVID-19 will be, so a key challenge is to design a fiscal countermeasure that clicks on when it’s needed and clicks off when it’s not. One approach that would fit that description would be to move immediately to pre-position a temporary cut in the payroll taxes that fund the Social Security and Medicare programs…

The final suggestion is a US-centric proposal, it is different from the income tax cut alluded to by President Trump and will directly benefit lower-income families, since healthcare costs will be a larger proportion of their after tax income. The authors’ propose a similar mechanism to click in when the unemployment rates rises and click off when re-employment kicks back in.

The table below shows actions taken by 4th March: –

Government response to COVID-19

Source: Economist

It is worth mentioning that Hong Kong, still reeling from the civil unrest of last year, has pressed ahead with ‘helicopter money’ sending cheques to every tax payer. This approach may be more widely adopted elsewhere over the coming weeks.

The Spanish Flu

In an attempt to find an historical parallel for the current Corona outbreak, there are only two episodes which are broadly similar, the Black Death of 1347 to 1351 and the Spanish Flu of 1918 to 1919. Data from the middle ages is difficult to extrapolate but it is thought that the Plague wiped out between 20% and 40% of Europe’s population. The world population is estimated to have fallen from 475mnl to between 350mln and 375mln. The world economy shrank, but, if data for England is any guide, per capita economic activity increased and the economic wellbeing of the average individual improved. For more on this topic I would recommend a working paper from the Federal Trade Commission – The English Economy Following the Black Death by Judith R. Gelman -1982.

The Spanish Flu of 1918 was the next global pandemic. It began in August of 1918, three month prior to the end of the First World War, and, by the time it had ended, in March of 1919, it had infected 500mln out of a global population of 1.8bln. The fatality rate was high, 40mln people lost their lives. Following the war, which cost almost 20mln lives, the combined loss of life was similar in absolute terms to the Black Death although in percentage terms the fatality rate was only 2%.

An excellent assessment of the Spanish epidemic can be found in the Economic Effects of the 1918 Influenza Pandemic – Thomas A. Garrett – Federal Reserve Bank of St Louis – 2007 – here are some key findings: –

The possibility of a worldwide influenza pandemic… is of growing concern for many countries around the globe. The World Bank estimates that a global influenza pandemic would cost the world economy $800 billion and kill tens-of-millions of people. Researchers at the U.S. Centers for Disease Control and Prevention calculate that deaths in the United States could reach 207,000 and the initial cost to the economy could approach $166 billion, or roughly 1.5 percent of the GDP. Longrun costs are expected to be much greater. The U.S. Department of Health and Human Services paints a more dire picture—up to 1.9 million dead in the United States and initial economic costs near $200 billion.

Despite technological advances in medicine and greater health coverage throughout the 20th century, deaths from a modern-day influenza pandemic are also likely to be related to race, income and place of residence.

The Spanish-flu was different from COVID-19 in that the highest mortality was among those aged 18 to 40 years and was often found among those with the strongest immune systems.

Garrett goes on to assess the economic impact with the aid stories from newspapers and the limited amount of previously published (and some unpublished) research. National statistics on unemployment and economic activity had yet to be compiled, but the simultaneous supply and demand shocks were broadly similar to the patterns we are witnessing today.

…One research paper examines the immediate (short-run) effect of influenza mortalities on manufacturing wages in U.S. cities and states for the period 1914 to 1919. The testable hypothesis of the paper is that

influenza mortalities had a direct impact on wage rates in the manufacturing sector in U.S. cities and states during and immediately after the 1918 influenza. The hypothesis is based on a simple economic model of the labor market: A decrease in the supply of manufacturing workers that resulted from influenza mortalities would have had the initial effect of reducing manufacturing labor supply, increasing the marginal product of labor and capital per worker, and thus increasing real wages. In the short term, labor immobility across cities and states is likely to have prevented wage equalization across the states, and a substitution away from relatively more expensive labor to capital is unlikely to have occurred.

The empirical results support the hypothesis: Cities and states having greater influenza mortalities experienced a greater increase in manufacturing wage growth over the period 1914 to 1919.

Another study explored state income growth for the decade after the influenza pandemic using a similar methodology. In their unpublished manuscript, the authors argue that states that experienced larger numbers of influenza deaths per capita would have experienced higher rates of growth in per capita income after the pandemic. Essentially, states with higher influenza mortality rates would have had a greater increase in capital per worker, and thus output per worker and higher incomes after the pandemic. Using state-level personal income estimates for 1919-1921 and 1930, the authors do find a positive and statistically significant relationship between state-wide influenza mortality rates and subsequent state per capita income growth.

Aside from wages, however the author concludes: –

…Most of the evidence indicates that the economic effects of the 1918 influenza pandemic were short-term. Many businesses, especially those in the service and entertainment industries, suffered double-digit losses in revenue. Other businesses that specialized in health care products experienced an increase in revenues.

How did financial markets react? The chart below shows the Dow Jones Industrial Average over the period from 1918 to 1923. The shaded areas indicate recessions: –

dow-jones- 1918 to 1923 Macrotrends

Source: Macrotrends

When reinvested dividends are included, the total return of the Dow Jones Industrial Average in 1918 was 10.5%, despite influenza wiping out 0.4% of the US population. Fears about a slowdown in economic activity, resulting from the end of WWI, were the underlying cause of the brief recession which coincided with the pandemic, the stock market had already reacted, dipping around 10% earlier in the year. The subsequent recession of 1920 had other causes.

As is evident from the chart below, the newly created (1913) Federal Reserve felt no compunction to cut interest rates: –

fredgraph

Source: Federal Reserve Bank of St Louis

US 10 year Treasury Bonds simply reflected the actions of the Federal Reserve: –

US Bonds Jan 1918 to Dec 1919

Source: ECB

One is forced to concede, financial markets behaved in a very different manner 100 years ago, but they may yet have something to teach us about the global impact of a pandemic – that it is an economic interruption rather than a permanent impediment to progress.

Conclusions and investment opportunities

Whilst there are similarities between the Spanish Flu of 1918 and the COVID-19 pandemic of today, there are also profound differences. Urban areas, for example, are expected to suffer higher fatalities than rural areas today. In 1919 only 51% of the population of the US was urban, today it is above 80%. Population density has also increased three-fold over the last century, if 500mln were infected in 2018/2019 then the comparable figure today would be 1.5bln. Changes in the ease of transportation mean that the spread of a pandemic will be much more rapid today than in the first quarter of the 20th century. Tempering this gloom, for many people, communications have transformed the nature of work. Many aspect of business can now be transacted remotely. Unlike in 1918 self-isolation will not bring commerce to a standstill.

The economic impact will also be felt more rapidly. Supply chains have been optimised for efficiency, they lack resilience. Central banks have already begun to cut interest rates (where they can) and provide liquidity. Governments have picked up the gauntlet with a range of fiscal measures including tax cuts and benefit payments.

Many commentators are calling the COVID-19 pandemic a Black Swan event, yet SARS (2003), H1N1 (2009), and MERS (2012) preceded this outbreak. Predictions that just such an event would occur have been circulating for more than a decade.

Financial markets have behaved predictably. The oil price has collapsed as Saudi Arabia has broken with the OPEC cartel, stocks have fallen (especially those related to oil) and government bonds have rallied. Gold, which saw significant inflows during the last few years, has vacillated as holders have liquidated to meet commitments elsewhere even as new buyers have embraced the time-honoured ‘safe haven.’ Looking ahead, we do not know how long this pandemic will last nor how widespread it will become. The two prior pandemics of a similar stature provide little useful guidance, the Spanish Flu lasted seven months, the Black Death, by contrast, spread over more than four years and was still flaring up into the 17th century.

Expectations of a cure and a vaccine remain a matter of conjecture, but epidemiologists suggest that within a year we will have a viable solution. At the time of writing (Wednesday 11th March) the total number of infections has reached 120,588, there have been 4,365 deaths while 66,894 patients have recovered – a 55.47% recovery rate, although the Chinese recovery rate has been steadily rising and now stands at 76.22%. The global fatality rate is 3.62%, whilst individual country fatality rates range from Italy at 6.22% to South Korea (where 210,000 people have been tested – ten times the per capita global average) at a heartening 0.79%. The WHO still expect the fatality rate to stabilise at around 1% which implies that 99% should eventually recover.

Whilst a larger correction in stocks should not be ruled out, the relative lack of selling pressure suggests that investors are prepared to reappraise their estimates of what price to earnings they will accept – remember interest rates have been cut and will probably be cut again. Where rates can be lowered no further, quantitative easing (including the purchase of stocks) and fiscal stimulus will aim to preserve value.

The historical evidence of the Spanish Flu suggests this pandemic will be short-lived. The recent market correction may prove sufficient but, with only two data points in more than 600 years, it is unwise to assume that it will not be different this time. Defensive equity strategies which focus on long-term value have been out of favour for more than a decade. Good companies with strong balance sheets and low levels of debt are well placed to weather any protracted disruption. They may also benefit from rotation out of index funds. When markets stabilise, the reduced level of interest rates will see a renewed wave of capital pouring into stocks. The only question today is whether there will be another correction or whether now is the time to buy.

When the facts change

When the facts change

In the Long Run - small colour logo

Macro Letter – No 126 – 14-02-2020

When the facts change

  • The coronavirus is a human tragedy, but the markets remain sanguine
  • A slowing of global growth is already factored into market expectations
  • Further central bank easing is expected to calm any market fears
  • A pick up in import price inflation has been discounted before it arrives

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Is the impact of Covid-19 going to be seen in economic data? Absolutely. Will economic growth slow? Yes, though it will be felt most in Wuhan and the Hubei region, a region estimated to account for 4.5% in Chinese GDP and 7% of autopart manufacture. The impact will be less pronounced in other parts of the world, although Korea’s Hyundai has already ceased vehicle production at its factories due to a lack of Chinese car parts.

Will there be a longer-term impact on the global supply chain and will this affect stock and bond prices? These are more difficult questions to answer. Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs. The longer-term impact remains unclear. Why? Because the performance of the stock market over the last decade has been driven almost entirely by the direction of interest rates, whilst economic growth, since the financial crisis, has been anaemic at best. As rates have fallen and central banks have purchased bonds, so bond yields have declined making stocks look relatively more attractive. Some central banks have even bought stocks to add to their cache of bonds, but I digress.

Returning to my title, from an investment perspective, have the facts changed? Global economic growth will undoubtedly take a hit, estimates of 0.1% to 0.2% fall in 2020 already abound. In order to mitigate this downturn, central banks will cut rates – where they can – and buy progressively longer-dated and less desirable bonds as they work their way along the maturity spectrum and down the credit-structure. Eventually they will emulate the policy of the Japanese and the Swiss, by purchasing common stocks. In China, where the purse strings have been kept tight during the past year, the PBoC has already ridden to the rescue, flooding the domestic banking system with $173bln of additional liquidity; it seems, the process of saving the stock market from the dismal vicissitudes of a global economic slow-down has already begun.

Growth down, profits down, stocks up? It sounds absurd but that is the gerrymandered nature of the current marketplace. It is comforting to know, the central banks will not have to face the music alone, they can rely upon the usual allies, as they endeavour to keep the everything bubble aloft. Which allies? The corporate executives of publically listed companies. Faced with the dilemma of expanding capital expenditure in the teeth of an economic slowdown – which might turn into a recession – the leaders of publically listed corporations can be relied upon to do the honourable thing, pay themselves in stock options and buyback more stock.

At some point this global Ponzi scheme will inflect, exhaust, implode, but until that moment arrives, it would be unwise to step off the gravy-train. The difficulty of staying aboard, of course, is the same one as always, the markets climb a wall of fear. If there is any good news amid the tragic Covid-19 pandemic, it is that the January correction has prompted some of the weaker hands in the stock market to fold. When markets consolidate on a high plateau, should they then turn down, the patient investor may be afforded time to exit. This price action is vastly preferable to the hyperbolic rise, followed by the sharp decline, an altogether more cathartic and less agreeable dénouement.

Other Themes and Menes

As those of you who have been reading my letters for a while will know, I have been bullish on the US equity market for several years. That has worked well. I have also been bullish on emerging markets in general – and Asia in particular – over a similar number of years. A less rewarding investment. With the benefit of hindsight, I should have been more tactical.

Looking ahead, Asian economies will continue to grow, but their stock markets may disappoint due to the uncertainty of the US administrations trade agenda. The US will continue to benefit from low interest rates and technological investment, together with buy-backs, mergers and privatisations. Elsewhere, I see opportunity within Europe, as governments spend on green infrastructure and other climate conscious projects. ESG investing gains more advocates daily. Socially responsible institutions will garner assets from socially responsible investors, while socially responsible governments will award contracts to those companies whose behaviour is ethically sound. It is a virtuous circle of morally commendable, albeit not necessarily economically logical, behaviour.

The UK lags behind Europe on environmental issues, but support for business and three years of deferred capital investment makes it an appealing destination for investment, as I explained last December in The Beginning of the End of Uncertainty for the UK.

Conclusions

Returning once more to my title, the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy. The chart below shows the diminishing power of the credit multiplier effect – Japan began their monetary experiment roughly a decade earlier than the rest of the developed world: –

Credit Multiplier

Source: Allianz/Refinitiv

Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

The Beginning of the End of Uncertainty for the UK

The Beginning of the End of Uncertainty for the UK

In the Long Run - small colour logo

Macro Letter – No 124 – 20-12-2019

The Beginning of the End of Uncertainty for the UK

  • The UK election result was a clear mandate for Brexit
  • A UK/EU free-trade agreement may not be ready by December 2020
  • Uncertainty remains but real economic progress can now begin

For traders and investors in financial markets, risk and reward are two sides of a single coin. There are, of course, exceptions and geopolitical risk is one of them. The difficulty with geopolitical risk is that it is really geopolitical uncertainty. As Frank Knight observed back in 1921 in Risk, Uncertainty and Profitrisk is can be measured and forecast, uncertainty, cannot: –

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.

I have kept this in mind throughout my investing career and it is for this reason that I have avoided investing in the UK stock market since the Brexit referendum. The uncertainty surrounding Brexit has not disappeared, but I now have sufficient confidence in the decisiveness of the incumbent administration to believe that progress can at last be made. To judge by the immediate reaction of financial markets in the wake of the UK election result, I am not alone in my optimism.

To begin, here is a chart of G7 GDP since Q2 2016: –

GDP comparison since 2016

Source: OECD

The UK has fared better than Japan and Italy but its momentum has diminished relative to the remainder of G7.

A more nuanced view of the relative underperformance of the UK is revealed by comparison with Eurozone growth. The chart below, which starts in 2014, shows the switch from UK outperformance to underperformance which began even before the Brexit referendum in mid-2016: –

GDP UK v EU

Source: Eurostat, Full Fact

Whilst there are many factors which have contributed to this change in the UK growth rate, the principal factor has been uncertainty relating to Brexit.

Of course, the direct impact of the Brexit referendum was felt by Sterling. The chart below shows the (Trade-weighted) Sterling Effective Exchange Rate since 2016: –

Sterling Effective Exchange Rate since 2016

Source: Bank of England

The rise since August 2019 appears to predict the outcome of the election, but the currency still has far to rise if it is to return to pre-financial crisis levels, as this 20 year chart reveals: –

Sterling Effective Exchange Rate since 2000

Source: Bank of England

The strong upward momentum which began in 2012 was swiftly terminated by the political morass which culminated in the UK referendum. The unexpected outcome of the 2016 Brexit vote only served to exacerbate the malaise.

The weakness of Sterling merely accelerated the deterioration in the UK terms of trade. The UK has run a continuous trade deficit since 1998 but, as the chart below reveals, the deficit has become structural: –

UK Trade Balance

Source: ONS

Any significant imbalance in trade makes an economy sensitive to changes in the value of its currency. The fall in Sterling since 2016 has had a knock on effect on the rate of UK inflation: –

united-kingdom-inflation-cpi since 2016

Source: ONS, Trading Economics

Viewed from a 10 year perspective, the reversal is even more pronounced. UK interest rates would probably have been substantially lower during the last four years had it not been for the uncertainty surrounding Brexit: –

united-kingdom-inflation-cpi since 2010

Source: ONS, Trading Economics

Is optimism now justified?

Aside from the trade balance, the charts above are a reflection of the discount financial markets have imposed on the UK. This month’s election justifies a rerating. Whilst the markets have not been overly enamoured with the latest Tory Brexit deal they have been craving certainty. A working majority of 80 allows room for any Conservative dissenters to be quashed. Then there is the ‘Corbyn Factor.’ Promises of widespread nationalisation, without clarity about the price with which private investors would be compensated, did not sit well. Neither did the proposed tax increases required to fuel the £80bln increase in fiscal spending. That threat has now passed.

Finally there was clarification of the nation’s opinion on Brexit itself. Labour lost ground almost everywhere; to Tories and the Brexit party in England and Wales, whilst in Scotland they ceded ground to the SNP.

This summation of the UK situation is an over-simplification, but from a financial market perspective the UK political landscape has improved. Suffice to say, there remain many challenges ahead, not least the Brexit transition period (end 2020) during which a free-trade agreement (FTA) needs to be agreed to avert unnecessary trade disruption. After four years, one might hope there has been behind the scenes preparation and that much of the deal will be a slight amendment to current access arrangements. In reality to complete a deal by year-end 2020 it will have to be an ‘FTA-lite’ affair, which may prove less than satisfactory. A swift trade deal should, nonetheless, reduce uncertainty which is also in the interests of the EU. I remain sceptical, there may be many a slip twixt cup and lip.

Conclusions and Investment Opportunities

Four years of deferred investment and consumption will now gradually be unleashed. This should bolster Sterling. As the Pound rises inflation should fall. Assuming they do not give up on their inflation target, currency strength should prompt the Bank of England to ease monetary conditions. Gilt yields will decline, forcing investors to seek longer duration bonds or higher credit risk to compensate for the shortfall in returns. Companies will find it easier to issue debt in order to fuel capital expenditure: although I expect it may lead to more share buybacks too. UK equity markets will rise, driven by an improved outlook for inflation, a lowering of interest rates and expectations of stronger economic growth.

For equity investors, this rising tide will float most ships, but not all companies will benefit equally. Those firms which were at risk of nationalisation have been immediate beneficiaries. The chart below tracks their relative underperformance: –

UK Nationalisation Tragets v FTSE 350

Source: Bloomberg, The Economist

A longer term investment opportunity should be found in the FTSE 250. The four year picture is found below (FTSE 100 in blue, FTSE 250 in red): –

FTSE 100 vs 250 - 4yr

Source: AJ Bell

It might appear as if the FTSE 250 has already caught up with the FTSE 100, but this next chart reveals a rather different picture: –

FTSE 100 vs 250 10yr

Source: AJ Bell

The FTSE 250 is much more closely entwined with the fortunes of the domestic UK economy. For the past four years many business plans in the UK have been on hold, awaiting clarity on Brexit. Now that a deal will be done and an FTA with the EU will follow, we may have finally reached the beginning of the end of uncertainty.

Leveraged Loans – History Rhyming?

Leveraged Loans – History Rhyming?

In the Long Run - small colour logo

Macro Letter – No 123 – 29-11-2019

Leveraged Loans – History Rhyming?

  • Despite three Federal Reserve rate cuts, leveraged loan credit quality is rapidly declining
  • Covenant-lite issues now account for more than 80% of US$ issues
  • CLO managers, among others, may need to sell, but few buyers are evident

For those of you who have not read Michael Lewis’s, The Big Short, the great financial crisis of 2008/2009 was caused by too much debt. The sector which precipitated the great unravelling was the US mortgage market and the particular instrument of mass destruction was the collateralised debt obligation, a security that turned out to be far from secure.

Today, more than a decade on from the crisis, interest rates are close to historic lows throughout much of the developed world. The problem of too much debt has been solved with even more debt. The nature of the debt has changed, so too has the make-up of debtors and creditors, but the very low level of interest rates, when compared to 2008, means that small changes in interest rates have a greater impact the price of credit.

Here is a hypothetical example, to explain the changed relationship between interest rates and credit. Back in 2008 a corporate borrower might have raised capital by issuing debt paying 6%, today the same institution can borrow at 3%. This means they can double the amount of capital raised by debt financing without any change in their annual interest bill. Put another way, apart from the repayment of the principal, which can usually be rolled over, the cost of debt financing has halved over the course of the decade. Firms can raise capital by issuing equity or debt, but, as interest rates decline, debt has become cheaper than equity finance.

In the example above, however, assuming the corporation chooses to double its borrowings, it becomes twice as sensitive to changes in interest rates. A rise from 3% to 4% increases its interest payments by one third, whereas, previously, a rise from 6% to 7% amounted to an increase of just one sixth.

So much for the borrower, but what about the lender? Bonds and other interest bearing securities are generally purchased by investors who need to secure a stable, long-term, stream of fixed income. As interest rates fall they are faced with a dilemma, either accept a lower return or embrace greater risk of default to achieve the same income. At the heart of the financial crisis was the illusion of the free lunch. By securitising a diversified portfolio of high-risk debt, the individual default risk was supposed to be ameliorated. The supposition was that non-correlated investments would remain non-correlated. There is a saying in financial markets, ‘during a crisis, correlations all rise to one.’ In other words, diversification seldom works when you really need it because during a crisis every investor wants the same thing, namely liquidity. Even if the default risk remains unchanged, the market liquidity risk contrives to wipe the investor out.

An alternative to a fixed-income security, which may be especially attractive in a rising interest rate environment (remember the Fed was tightening for a while prior to 2019), is a floating-rate investment. In theory, as short-term interest rates rise the investor can reinvest at more attractive rates. If the yield curve is essentially flat, floating rate investments will produce similar income streams to longer maturity investments, but they will be less sensitive to systemic market risk because they have shorter duration. In theory, credit risk should be easier to manage.

What’s new?

More than ten years into the recovery, we are witnessing one of the longest equity bull-markets in history, but it has been driven almost entirely by falling interest rates. The bond market has also been in a bull-trend, one which commenced in the early 1980’s. For investors, who cannot stomach the uncertainty of the equity market, the fixed income market is a viable alternative, however, as government bond yields have collapsed, income-yielding investments have been increasingly hard to find. With fixed income losing its lustre, credit products have sought to fill the void. Floating-rate leveraged loans, often repackaged as a collateralised loan obligation (CLO), are proving a popular alternative source of income.

The typical CLO is a floating-rate tradable security backed by a pool of, usually, first-lien loans. Often these are the debt of corporations with poor credit ratings, such as the finance used by private equity firms to facilitate leveraged buyouts. On their own, many of these loans rank on the margins of investment grade but, by bundling them together with better rated paper, CLO managers transform base metal into gold. The CLO manager does not stop there, going on to dole out tranches, with different credit risks, to investors with differing risk appetites. There are two general types of tranche; debt tranches, which pay interest and carry a credit rating from an independent agency, and equity tranches, which give the purchaser ownership in the event of the sale of the underlying loans. CLOs are hard to value, they are actively managed meaning their risk profile is in a constant state of flux.

CLOs are not new instruments and studies have shown that they are subject to lower defaults than corporate bonds. This is unsurprising since the portfolios are diversified across many businesses, whilst corporate bonds are the debt of a single issuer. CLO issuers argue that corporations are audited unlike the liar loans of the sub-prime mortgage debacle and that banks have passed ‘first loss’ risk on to third parties. I am not convinced this will save them from a general collapse in confidence. Auditors can be deceived and the owners of the ‘first loss’ exposure will need to hedge. CLOs may be diversified across multiple industry sectors but the market price of the underlying loans will remain highly dependent on that most transitory of factors, liquidity.

Where are we now?

Enough of the theory, in practice many CLOs are turning toxic. According to an October article in the American Banker –  A $40 billion pile of leveraged loans is battered by big lossesthe loans of more than 50 companies have seen their prices decline by more than 10%. The slowing economy appears to be the culprit, credit rating agencies are, as always, reactive rather than proactive, so the risk that many CLOs may soon cease to be investment grade is prompting further selling, despite the absence of actual credit downgrades. The table below shows magnitude of the problem as at the beginning of last month: –

Leveraged Loans

Source: Bloomberg

It is generally agreed that the notional outstanding issuance of US$ leveraged loans is around $1.2trln, of which some $660bln (55%) are held in CLOs, however, a recent estimate from the Bank of England – How large is the leveraged loan market? suggests that the figure is closer to $1.8trln. The authors go on to state: –

We estimate that there is more than US$2.2 trillion in leveraged loans outstanding worldwide. This is larger than the most commonly cited estimate and comparable to US subprime before the crisis.

As global interest rates have declined the leveraged loan market has more than doubled in size since its post crisis low of $497bln in 2010. Being mostly floating-rate structures, enthusiasm for US$ loans accelerated further in the wake of Federal Reserve (Fed) tightening of short-term rates. This excess demand has undermined quality, it is estimated that around 80% of US$ and 90% of Euro issues are covenant-lite – in other words they have little detailed financial information, often relying on the EBITDA adjustments calculated by the executives of the corporations issuing the loans. Those loans  not held by CLOs sit on the balance sheet of banks, insurance companies and pension funds together with mutual funds and ETFs. Several more recent issues, failing to find a home, sit on the balance sheets of the underwriting banks.

Here is a chart showing the evolution of the leveraged loan market over the last decade: –

CLOs

Source: BIS

Whilst the troubled loans in the first table above amount to less than 4% of the total outstanding issuance, there appears to be a sea-change in sentiment as rating agencies begin to downgrade some issues to CCC – a notch below investment grade. This grade deflation is important because most CLO’s are not permitted to hold more than 7.5% of CCC rated loans in their portfolios. Some estimates suggest that 29% of leveraged loans are rated just one notch above CCC. Moody’s officially admits that 40% of junk-debt issuers rate B3 and lower. S&P announced that the number of issuers rated B- or lower, referred to as ‘weakest links’, rose from 243 in August to 263 in September, the highest figure recorded since 2009 when they peaked at 300. S&P go on to note that in the largest industry sector, consumer products, downgrades continue to outpace upgrades.

As the right-hand of the two charts above reveals, the debt multiple to earnings of corporate loans is at an all-time high. Not only has the number of issuer downgrades risen but the number of issuers has also increased dramatically. At the end of 2010 there were 658 corporate issuers, by October 2019 the number of issuers had swelled 56% to 1025.

The credit spread between BB and the Leveraged Loan Index has been widening throughout the year despite three rate reductions from the Fed: –

Lev Loans spreads

Source: Morgan Stanley, FTSE

Q4 2018 saw a sharp decline in prices as the effect of previous Fed tightening finally took its toll. Then the Fed changed tack, higher grade credit recovered but the Leveraged Loan Index never followed suit.

Despite a small inflow into leveraged loan ETFs in September, the natural buyers of sub-investment grade paper have been unnaturally absent of late. Leveraged loan mutual funds have seen steady investment outflows for almost a year.

The inexperience of the new issuers is matched by the inexperience of the investor base. According to data from Prequin, between 2013 and 2017 a total of 322 funds made direct lending investments of which 71 had never entered the market before, during the previous five year only 85 funds had made investments of which just 19 were novices.

Inexperienced investors often move as one and this is evident in the recent absence of liquidity. The lack of willing buyers also highlights another weakness of the leveraged loan market, a lack of transparency. Many of the loans are issued by private companies, information about their financial health is therefore only available to existing holders of their equity or debt. Few existing holders are inclined to add to their exposure in the current environment. New purchasers are proving reticence to fly blind, as a result liquidity is evaporating further just at the moment it is most needed.

If the credit ratings of leveraged loans deteriorate further, contagion may spill over into the high-yield bond market. Whilst the outstanding issuance of high-yield bonds has been relatively stable, the ownership, traditionally insurers and pension funds, has been swelled by mutual fund investors and holders of ETFs. These latter investors prize liquidity more highly than longer-term institutions: the overall high-yield investor base has become less stable.

Inevitably, commentators are beginning to draw parallels with mortgage and CDO crisis. The table below, from the Bank of England report, compares leveraged loans today with sub-prime mortgages in 2006: –

how-large-is-the-leveraged-loan-market-chart-a

Source: Bank of England

The comparisons are disquieting, the issuers and underlying assets of the leveraged loan market may be more diversified than the mortgages of 2006, but, with interest rates substantially lower today, the sensitivity of the entire market, to a widening of credit spreads, is considerably greater.

The systemic risks posed by a meltdown in the CLO market is not lost on the BIS, page 11 of the latest BIS Quarterly Review – Structured finance then and now: a comparison of CDOs and CLOs observes: –

…the deteriorating credit quality of CLOs’ underlying assets; the opacity of indirect exposures; the high concentration of banks’ direct holdings; and the uncertain resilience of senior tranches, which depend crucially on the correlation of losses among underlying loans.

These are all factors to watch closely. The authors’ remain sanguine, however, pointing out that CLOs are generally less complex than CDOs, containing little credit default swap or resecuritisation exposure. They also note that CLOs are less frequently used as collateral in repurchase agreements rendering them less likely to be funded by short-term capital. This last aspect is a double-edge sword, if a security has a liquid repo market it can easily be borrowed and lent. A liquid repo market allows additional leverage but it also permits short-sellers to provide essential liquidity during a buyers strike, in the absence of short-sellers there may be no one to provide liquidity at all.

In terms of counterparties, the table below shows which institutions have the largest exposure to leveraged loans: –

BOE CLO heat map

Source: Bank of England

Bank exposure is preeminent but the flow from CLOs will strain bank balance sheets, especially given the lack of repo market liquidity.

Conclusions and Investment Opportunities

The CLO and leveraged loan market has the capacity to destabilise the broader financial markets. Rate cuts from the Fed have been insufficient to support prices and economic headwinds look set to test the underlying businesses in the next couple of years. A further slashing of rates and balance sheet expansion by the Fed may be sufficient to stave off a 2008 redux but the warning signs are flashing amber. Total financial market leverage is well below the levels that preceded the financial crisis of 2008, but as Mark Twain is purported to have said, ‘History doesn’t repeat but it rhymes.’

Until the US election in November 2020 is past, equity markets should remain supported. Government bond yields are unlikely to rise and, should signs of economic weakness materialise, may plumb new lows. Credit spread widening, however, even as government bond yields decline, is a pattern which will become more prevalent as the cash-flow implications of floating-rate borrowing instil some much needed sobriety into the market for leveraged loans. With interest rates close to historic lows credit markets are, once again, the weakest link.