Leveraged Loans – History Rhyming?

Leveraged Loans – History Rhyming?

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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.

The Economic Future of a Negative Interest Rate World

The Economic Future of a Negative Interest Rate World

The Economic Future of a Negative Interest Rate World

In this second AIER article I look at the wider implications of negative interest rates.

The Economic Future of a Negative Interest Rate World

To read the previous article, please click here

 

 

 

 

Interest Rates, Global Value Chains and Bank Reserve Requirements

Interest Rates, Global Value Chains and Bank Reserve Requirements

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Macro Letter – No 117 – 28-06-2019

Interest Rates, Global Value Chains and Bank Reserve Requirements

  • Global Value Chains have suffered since 2009
  • Despite low interest rates, financial costs remain too high
  • Bank profitability has not recovered, yet banks are still too big to fail

In a recent speech, Hyun Song Shin, Head of Research at the BIS, discussed – What is behind the recent slowdown? The speech focused on the weakening of global value chains (GVC’s) in manufactured goods. The manufacturing sector is critical, since it accounts for 70% of global merchandise trade: –

During the heyday of globalisation in the late 1980s and 1990s, trade grew at twice the pace of GDP. In turn, trade growth in manufactured goods was driven by the growing importance of multinational firms and the development of GVCs that knit together the production activity of firms around the world.

The chart below reveals the transformation of the world economy over the past 17 years: –

The Arrival Of China 2000-2017

Source: BIS, X Li, B Meng and Z Wang, “Recent patterns of global production and GVC participation”, in D Dollar (ed), Global Value Chain Development Report 2019, World Trade Organization et al.

Hyun’s next chart tracks the sharp reversal in the relationship between world trade and GDP growth as a result of the Great Financial Crisis (GFC): –

Ratio of World Goods to GDP 2000 - 2018

Sources: IMF, World Economic Outlook; World Trade Organization; Datastream; national data; BIS calculations

The important point, highlighted by Hyun, is that the retrenchment in trade occurred almost a decade before the trade war began. China, growing at 6% plus, has captured an increasing share of global trade at the expense of the developed nations, most notably the US. Europe went through a similar transition during the second half of the 19th century, as the US transformed from an agrarian to an industrial society.

Returning to the present, supporting GVCs is capital intensive. Historically low interest rates have allowed these chains to flourish, but the recent reversal of interest rate policy by the Federal Reserve has caused structural cracks to emerge in the edifice. The BIS describes the situation for multi-national manufacturing firms in this way (the emphasis is mine): –

…firms enmeshed in global value chains could be compared to jugglers with many balls in the air at the same time. Long and intricate GVCs have many balls in the air, necessitating greater financial resources to knit the production process together. More accommodative financial conditions then act like weaker gravity for the juggler, who can throw many more balls into the air, including large balls that represent intermediate goods with large embedded value. However, when the shadow price of credit rises, the juggler has a more difficult time keeping all the balls in the air at once.

When financial conditions tighten, very long and elaborate GVCs will no longer be viable economically. A rationalisation of supply chains through “on-shoring” and “re-shoring” of activity towards domestic suppliers, or to suppliers that are closer geographically, will help reduce the credit costs of supporting long GVCs. 

It is interesting to note the use of the phrase ‘shadow price of credit,’ this suggests that concern about the intermediation process by which changes in the ‘risk-free’ rate disseminate into the real-economy. In a 2014 study, the BIS Committee on the Global Financial System (CGFS) found that 65% of world trade is still financed through ‘open account financing’ or through the buyer paying in advance. For GVC’s, short-term US interest rates matter, especially when 80% of trade finance is still transacted in the US$. Even when rates reached their nadir, banks were reluctant to lend at such favourable terms as they had prior to the GFC. The recent rise in short-term interest rates has supported the US$, accelerating the reversal in the trade to GDP ratio.

A closer investigation of bank lending since the GFC reveals structural weakness in the intermediation process. Since 2009, at the same time as interest rates fell, bank capital requirements rose. The impact of this fiscal offsetting of monetary accommodation can be seen most clearly in the global collapse the velocity of circulation of money supply: –

Global Money Velocity - Tom Drake, BEA, FRED, ECB, BoJ, China NBS, UK ONS

Source: Tom Drake, National Data, Macrobond

The mechanism by which credit reaches the real economy has been choked. Banks have gradually repaired their balance sheets, but the absurd incentives, such as the inducement to purchase zero risk-weighted government debt rather than lending to corporates, have been given fresh impetus through a combination of structurally higher capital requirements and lower interest rates.

In their January 2018 publication – Structural changes in banking after the crisis – the BIS examines how credit intermediation has changed (the emphasis is mine): –

The crisis revealed substantial weaknesses in the banking system and the prudential framework, which had led to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers…

There is no clear evidence of systematic and long-lasting retrenchment of banks from credit intermediation. The severity of the crisis was not uniform across banks and systems. Weaker banks cut back credit more strongly, and riskier borrowers saw their access to credit more tightly curtailed. In the immediate aftermath of the crisis the response of policymakers and bank managers was also differentiated across systems, with some moving more decisively than others to address the problems revealed. Bank credit has since grown relative to GDP in most jurisdictions, but has not returned to pre-crisis highs in the most affected countries, reflecting necessary deleveraging and the unwinding of pre-crisis excesses. While disentangling demand and supply drivers remains a challenging exercise, the evidence gathered by the Working Group does not point to systematic change in the willingness of banks to lend locally. In line with the objectives of post-crisis reforms, lenders have become more sensitive to risk and more discriminating across borrowers

The last two sentences appear to contradict, but measuring of loan quality from without is always a challenge. The authors’ continue to perceive credit quality and intermediation, through a glass darkly (once again, the emphasis is mine): –

If anything, the shift towards commercial banking activities suggests that banks are putting more emphasis on lending than trading activities. Still, given the range of changes in the banking sector over the past decade, policymakers should remain attentive to potential unintended “gaps” in credit to the real economy. Legacy asset quality problems can be an obstacle to credit growth. Excessive pre-crisis credit growth left a legacy of problem assets, especially high levels of NPLs, which continue to distort the allocation of fresh credit in several countries…

Persistently high NPLs are likely to lead to greater ultimate losses, impede credit growth and distort credit reallocation, potentially incentivising banks to take on more risk….

Again, the evidence seems to be contradictory. What is different between the cyclical patterns of the past and the current state of affairs? The tried and tested central bank solution to previous crises, stretching all the way back to the 1930’s, if not before, is to cut short-term interest rates – regardless of the level of inflation. The yield curve steepens sharply and banks rapidly repair their balance sheets by borrowing short-term and lending long-term. In the wake of the GFC, however, rates declined yet the economy failed to respond to the stimulus, at least in part, because the central banks accommodative actions were being negated by the tightening of regulatory conditions. Collectively the central banks and the national regulators were robbing Peter to pay Paul. The result (please pardon my emphasis once more): –

Post-crisis bank profitability has remained subdued. This reflects many factors, including bank-specific drivers (eg business model choices), cyclical macroeconomic drivers (eg low growth and interest rates) and structural drivers that will have a more persistent impact. An example of this latter group includes regulatory reforms that have implied lower leverage and the curbing of certain higher risk activities, and a reduction of implicit subsidies for large or systemically important banks…

…all else constant, lower leverage and reduced risk-taking should reduce return on equity. Sluggish revenues have dampened profits and, combined with low interest rates, may have contributed to the slower progress made by some banks in dealing with legacy problem assets…

Sufficient levels of capital are needed for banks to deal with unexpected shocks, and low profitability can weaken banks’ ability to maintain sufficient buffers. Banks that lack a steady stream of earnings to repair their capital base after an unexpected loss will have to rely on fresh equity issuance. Yet, markets are usually an expensive source of capital for banks, when accessed under duress….

In this scenario banks have an incentive to extend and reschedule zombie loans in order to avoid right-downs. Companies which should have been forced into administration linger on, banks’ ability to make new loans is curtailed and new ventures are starved of cash.

The BIS go on to make a number of suggestions in order to deal with low bank profitability and the problem of non-performing legacy assets: –

If overcapacity is a key driver of low profitability, institutional barriers to mergers must be reviewed and exit regimes applied. If the problem lies with legacy assets (such as NPLs), these should be fully addressed, which might entail a dialogue between prudential authorities and other policymakers (eg those in charge of mechanisms dealing with insolvency)…

The exit of financial institutions might be politically costly in the short run, but may pay off in the longer term through more stable banking systems, sounder lending and better allocation of resources. The implicit subsidisation of non-viable business models might have lower short-term costs but could lead to resource misallocation. Similarly, any assessment of consolidation trends needs to take into account potential trade-offs between efficiency and stability, as well as examine the nature and impact of barriers to exit for less profitable banks.

These suggestions make abundant sense but that is no guarantee the BIS recommendations will be heeded.

I am also concerned that the authors’ may be overly optimistic about the resilience of the global banking system: –

Compared with the pre-crisis period, banks are better capitalised and have lower exposure to liquidity and funding risks. They have also reduced activities that contributed to the build-up of vulnerabilities, such as exposure to high-risk assets, and excessive counterparty risk through OTC derivatives and repo transactions, among others. That said, given that markets have not yet evolved through a full financial cycle, bank restructuring efforts remain under way. In addition, as many relevant reforms have not yet been fully implemented, it is too early to assess their full effect.

Thankfully the BIS outlook is not entirely rose-tinted, they do acknowledge: –

…some trends in banking systems that we have observed since the crisis, such as the decline in wholesale funding, might be affected by unconventional monetary policy and may not persist. Success in addressing prior problems does not guarantee that banks will be able to respond to future risks…

Problems of bank governance and risk management contributed to the crisis and have been a key focus of reform. Given that the sources of future vulnerabilities are hard to predict, banks need to have robust frameworks of risk governance and management to identify and understand emerging risks and their potential impacts for the firm.

The BIS choose to gloss over the fact that many banks are still far too big to fail. They avoid discussing whether artificially low interest rates and the excessive flatness of yield curves may be contributing to a different breed of systemic risk. Commercial banks are for-profit institutions, higher capital requirements curtail their ability to achieve acceptable returns on capital. The adoption of central counterparties for the largest fixed income market in the world, interest rate swaps, whilst it reduces the risk for individual banking institutions, increases systemic risk for the market as a whole. The default of a systemically important central counterparties could prove catastrophic.

Conclusions and investment opportunities

The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.

US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.

Global Real Estate – Has the tide begun to recede?

Global Real Estate – Has the tide begun to recede?

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Macro Letter – No 113 – 19-04-2019

Global Real Estate – Has the tide begun to recede?

  • Despite the fourth quarter shakeout in stocks, real estate values keep rising
  • Financial conditions remain key, especially in a low rate environment
  • Isolated instances of weakness have yet to breed contagion
  • The reversal of central bank tightening has averted a more widespread correction

I last wrote about the prospects for global real estate back in February 2018 in Macro Letter – No 90 – A warning knell from the housing market – inciting a riot? I concluded: –

The residential real estate market often reacts to a fall in the stock market with a lag. As commentators put it, ‘Main Street plays catch up with Wall Street.’ The Central Bank experiment with QE, however, makes housing more susceptible to, even, a small rise in interest rates. The price of Australian residential real estate is weakening but its commodity rich cousin, Canada, saw major cities price increases of 9.69% y/y in Q3 2017. The US market also remains buoyant, the S&P/Case-Shiller seasonally-adjusted national home price index rose by 3.83% over the same period: no sign of a Federal Reserve policy mistake so far.

As I said at the beginning of this article, all property investment is ‘local’, nonetheless, Australia, which has not suffered a recession for 26 years, might be a leading indicator. Contagion might seem unlikely, but it could incite a riot of risk-off sentiment to ripple around the globe.

More than a year later, central bank interest rates seem to have peaked (if indeed they increased at all) bond yields in most developed countries are falling again and, another round of QE is hotly anticipated, at the first hint of a global, or even regional, slowdown in growth.

In the midst of this sea-change from tightening to easing, an article from the IMF – Assessing the Risk of the Next Housing Bust – appeared earlier this month, in which the authors remind us that housing construction and related spending account for one sixth of US and European GDP. A boom and subsequent bust in house prices has been responsible for two thirds of recessions during the past few decades, nonetheless, they find that: –

…in most advanced economies in our sample, weighted by GDP, the odds of a big drop in inflation-adjusted house prices were lower at the end of 2017 than 10 years earlier but remained above the historical average. In emerging markets, by contrast, riskiness was higher in 2017 than on the eve of the global financial crisis. Nonetheless, downside risks to house prices remain elevated in more than 25 percent of these advanced economies and reached nearly 40 percent in emerging markets in our study.

The authors see a particular risk emanating from China’s Eastern provinces but overall they expect conditions to remain reasonably benign in the short-term. The January 2019 IMF – Global Housing Watch – presents the situation as at Q2 and Q3 2018: –

housepricesaroundtheworld IMF, BIS, ECB,Federal Reserve, Savills, Sinyl Real Estate

Source: IMF, BIS, Federal Reserve, ECB, Savills, Sinyl, National Data

Hong Kong continues to boom and Ireland to rebound.

They go on to analyse real credit growth: –

creditgrowth IMF, Haver Analytics

Source: IMF, Haver Analytics

Interestingly, for several European countries (including Ireland) credit conditions have been tightening, whilst Hong Kong’s price rises seem to be underpinned by credit growth.

Then the IMF compare house prices to average income: –

pricetoincome IMF, OECD

Source: IMF, OECD

Canada comes to the fore-front but Ireland is close second with New Zealand and Portugal not far behind.

Finally the authors assess House price/Rent ratios: –

pricetorent IMF, OECD

Source: IMF, OECD

Both Canada, Portugal and New Zealand are prominent as is Ireland.

This one year snap-shot disguises some lower term trends. The following chart from the September 2018 – UBS Global Real Estate Bubble Index puts the housing market into long-run perspective.

ubs-bubbles-index

Source: UBS

UBS go on to rank most expensive cities for residential real estate, pointing out that top end housing prices declined in half of the list:-

real-estate-bubbles list UBS

Source: UBS

Over the 12 months to September 2018 UBS note that house prices declined in Milan, Toronto, Zurich, New York, Geneva, London, Sydney and Stockholm. The chart below shows the one year change (light grey bar) and the five year change (dark grey line): –

housing-bubbles-growth-rates 1yr - 5yr change UBS

Source: UBS

Is a global correction coming or is property, as always, local? The answer? Local, but with several local markets still at risk.

The US market is generally robust. According to Peter Coy of Bloomberg – America Isn’t Building Enough New Housing – the effect of the housing collapse during the financial crisis still lingers, added to which zoning rules are exacerbating an already small pool of construction-ready lots. Non-credit factors are also corroborated by a recent Fannie Mae survey of housing lenders which found only 1% blaming tight credit, whilst 48% pointed to lack of supply.

North of the border, in Canada, the outlook has become less favourable, partly due to official intervention which began in 2017. Since 2012, house price increases in Toronto accelerated away from other cities, Vancouver followed with a late rush after 2015 and price increases only stalled in the last year.

In their February 2019 report Moody Analytics – 2019 Canada Housing Market Outlook: Slower, Steadier – identify the risks as follows: –

Interventions by the BoC, OSFI, and the British Columbia and Ontario governments were by no means a capricious attempt to deflate a house price bubble for the mere sake of deflation. Financial and macroeconomic aggregates point to the possibility that the mortgage credit needed to sustain house price appreciation may be unsustainable. Since 2002, the ratio of mortgage debt service payments to disposable income has gone from a historical low point of little more than 5% in 2003 to almost 6.6% by the end of last year…

The authors go on to highlight the danger of the overall debt burden, should interest rates rise, or should the Canadian economy slow, as it is expected to do next year. They expect the ratio of household interest payments to disposable income to rise and the percentage of mortgage arrears to follow a similar trajectory. In reality the rate of arrears is still forecast to reach only 0.3%, significantly below its historical average.

External factors could create the conditions for a protracted slump in Canadian real estate. Moody’s point to a Chinese real estate crash, a no-deal Brexit, renewed austerity in Europe and a continuation of the US/China trade dispute as potential catalysts. In this scenario 4% of mortgages would be in arrears. For the present, however, Canadian housing prices remain robust.

Switching to China, the CBRE – Greater China Real Estate Market Outlook 2019 – paints a mixed picture of commercial real estate in the year ahead: –

Office: U.S.–China trade conflict and the ensuing economic uncertainty are set to dent office demand in mainland China and Hong Kong. Leasing momentum in Taiwan will be less affected. Office rents will likely soften in oversupplied and trade and manufacturing-driven cities in 2019.

Retail: The amalgamation of online and offline will continue to drive the evolution of retail demand on the mainland. Retailers in Hong Kong and Taiwan will adopt a conservative approach towards expansion due to the diminishing wealth effect. Retail rents are projected to stay flat or grow slightly in most markets across Greater China.

Logistics: Tight land and warehouse supply will translate into steady logistics rental growth in the Greater Bay Area, Yangtze River Delta and Pan-Beijing area. Risks include potential weaker leasing demand stemming from the U.S.-China trade conflict and the gradual migration to self-built warehouses by major e-commerce companies.

The Chinese housing market, by contrast, has suffered from speculative over-supply. Estimates last year suggested that 22% of homes, amounting to around 50 million dwellings, are unoccupied. Government intervention has been evident for several years in an attempt to moderate price fluctuations. Earlier this month the National Development and Reform Commission (NDRC) said it aims to increase China’s urbanization rate by at least 1% with the aim of tackling the surfeit of supply. This is part of a longer-term goal to bring 100 million people into the cities over the five years to 2020. As of last year, 59.6% of China’s population lived in urban areas. According to World Bank data high middle income countries average 65% rising to 82% for high income countries. For China to reach the average high middle income average, another 70mln people need to move from rural to urban regions.

The new NDRC strategy will include the scrapping of restrictions on household registration permits for non-residents in cities of one to three million. For cities of three to five million, restrictions will be “comprehensively relaxed,” although the NDRC did not specify the particulars. Banks will be incentivised to provide credit and the agency also stated that it will support the establishing of real estate investment trusts (REITs) in order to promote a deepening of the residential rental market.

The NDRC action might seem unnecessary, average prices of new homes in the 70 largest Chinese cities rose 10.4% in February, up from 10.0% the previous month. This is the 46th straight monthly price increase and the strongest annual gain since May 2017. Critics point to cheap credit as the principal driver of this trend, they highlight the danger to domestic prices should the government decide to constrain credit growth. The key to maintaining prices is to open the market to foreign capital, this month’s NDRC policy announcement is a gradual step in that direction. It is estimated that at least $50bln of foreign capital will flow China over the next five years.

Despite the booming residential property market, the Chinese government has been tightening credit conditions and cracking down on illegal financial outflows. This has had impacted Australia in particular, investment fell more than 36% to $.8.2bln last year, down from $13bln in 2017. Mining investment fell 90%, while commercial real estate investment declined by 32%, to $3bln from $4.4bln the previous year. Investment in the US and Canada fell even more, declining by 83% and 47% respectively. Globally, however, Chinese investment has continued to grow, rising 4.2%.

Australian residential housing prices, especially in the major cities, have suffered from this downdraft. According to a report, released earlier this month by Core Logic – Falling Property Values Drags Household Wealth Lower – the decline in prices, the worst in more than two decades, is beginning to bite: –

According to the ABS (Australian Bureau of Statistics), total household assets were recorded at a value of $12.6 trillion at the end of 2018. Total household assets have fallen in value over both the September and December 2018 quarters taking household wealth -1.6% lower relative to June 2018. While the value of household assets have fallen by -1.6% over the past two quarters, liabilities have increased by 1.5% over the same period to reach $2.4 trillion. As a result of falling assets and rising liabilities, household net worth was recorded at $10.2 trillion, the lowest it has been since September 2017…

As at December 2018, household debt was 189.6% of disposable income, a record high and up from 188.7% the previous quarter. Housing debt was also a record high 140.2% of disposable income and had risen from 139.5% the previous quarter.

In 2018 the Australian Residential Property Price Index fell 5.1%, worst hit was Sydney, down 7.8% followed by Melbourne, off 6.4%, Darwin, down 3.5% and Perth, which has been in decline since 2015, which shed a further 2.5%. The ABS cited tightening credit conditions and reduced demand from investors and owner occupiers.

According to many commentators, Australian property has been ready to crash since the bursting of the tech bubble but, as this chart shows, prices are rich but not excessive: –

AMP Capital - Australian housing since 1926

Source: AMP Capital

Conclusions and Investment Opportunities

The entire second chapter of the IMF – Global Financial Stability Report – published on 10th April, focusses on housing: –

Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. These macro-financial links arise from the many roles housing plays for households, small firms, and financial intermediaries, as a consumption good, long-term investment, store of wealth, and collateral for lending, among others. In this context, the rapid increase in house prices in many countries in recent years has raised some concerns about the possibility of a decline and its potential consequences…

Capital inflows seem to be associated with higher house prices in the short term and more downside risks to house prices in the medium term in advanced economies, which might justify capital flow management measures under some conditions. The aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, but the effects depend on the types of flows and may also be region- or city-specific. At the city level, case studies for Canada, China, and the United States find that flows of foreign direct investment are generally associated with lower future risks, whereas other capital inflows (largely corresponding to banking flows) or portfolio flows amplify downside risks to house prices in several cities or regions. Altogether, when nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.

Aside from some corrections in certain cities (notably Vancouver, Toronto, Sydney and Melboune) prices continue to rise in most regions of the world, spurred on by historically low interest rates and generally benign credit conditions. As I said in last month’s Macro Letter – China in transition – From manufacturer to consumer – China will need to open its borders to foreign investment as its current account switches from surplus to deficit. Foreign capital will flow into Chinese property and, when domestic savings are permitted to exit the country, Chinese capital will support real estate elsewhere. The greatest macroeconomic risk to global housing markets stems from a tightening of financial conditions. Central banks appear determined to lean against the headwinds of a recession. In the long run they may fail but in the near-term the global housing market still looks unlikely to implode.

Capital Flows – is a reckoning nigh?

Capital Flows – is a reckoning nigh?

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Macro Letter – No 111 – 15-03-2019

Capital Flows – is a reckoning nigh?

  • Borrowing in Euros continues to rise even as the rate of US borrowing slows
  • The BIS has identified an Expansionary Lower Bound for interest rates
  • Developed economies might not be immune to the ELB
  • Demographic deflation will thwart growth for decades to come

In Macro Letter – No 108 – 18-01-2019 – A world of debt – where are the risks? I looked at the increase in debt globally, however, there has been another trend, since 2009, which is worth investigating as we consider from whence the greatest risk to global growth may hail. The BIS global liquidity indicators at end-September 2018 – released at the end of January, provides an insight: –

The annual growth rate of US dollar credit to non-bank borrowers outside the United States slowed down to 3%, compared with its most recent peak of 7% at end-2017. The outstanding stock stood at $11.5 trillion.

In contrast, euro-denominated credit to non-bank borrowers outside the euro area rose by 9% year on year, taking the outstanding stock to €3.2 trillion (equivalent to $3.7 trillion). Euro-denominated credit to non-bank borrowers located in emerging market and developing economies (EMDEs) grew even more strongly, up by 13%.

The chart below shows the slowing rate of US$ credit growth, while euro credit accelerates: –

gli1901_graph1

Source: BIS global liquidity indicators

The rising demand for Euro denominated borrowing has been in train since the end of the Great Financial Recession in 2009. Lower interest rates in the Eurozone have been a part of this process; a tendency for the Japanese Yen to rise in times of economic and geopolitical concern has no doubt helped European lenders to gain market share. This trend, however, remains over-shadowed by the sheer size of the US credit markets. The US$ has remained preeminent due to structurally higher interest rates and bond yields than Europe or Japan: investors, rather than borrowers, dictate capital flows.

The EC – Analysis of developments in EU capital flows in the global context from November 2018 concurs: –

The euro area (excluding intra-euro area flows) has been since 2013 the world’s leading net exporter of capital. Capital from the euro area has been invested heavily abroad in debt securities, especially in the US, taking advantage of the interest differential between the two jurisdictions. At the same time, foreign holdings of euro-area bonds fell as a result of the European Central Bank’s Asset Purchase Programme.

This bring us to another issue; a country’s ability to service its debt is linked to its GDP growth rate. Since 2009 the US economy has expanded by 34%, over the same period, Europe has shrunk by 2%. Putting these rates of expansion into a global perspective, the last decade has seen China’s economy grow by 139%, whilst India has gained 96%. Recent analysis suggests that Chinese growth may have been overstated by 2% per annum over the past decade, but the pace is still far in excess of developed economy rates. Concern about Chinese debt is not unwarranted, but with GDP rising by 6% per annum, its economy will be 80% larger in a decade, whilst India’s, growing at 7%, will have doubled.

Another excellent research paper from the BIS – The expansionary lower bound: contractionary monetary easing and the trilemma – investigates the problem of monetary tightening of developed economies on emerging markets. Here is part of the introduction, the emphasis is mine: –

…policy makers in EMs are often reluctant to lower interest rates during an economic downturn because they fear that, by spurring capital outflows, monetary easing may end up weakening, rather than boosting, aggregate demand.

An empirical analysis of the determinants of policy rates in EMs provides suggestive evidence about the tensions faced by monetary authorities, even in countries with flexible exchange rates.

…The results reveal that, even after controlling for expected inflation and the output gap, monetary authorities in EMs tend to hike policy rates when the VIX or US policy rates increase. This is arguably driven by the desire to limit capital outflows and the depreciation of the exchange rate.

…our theory predicts the existence of an “Expansionary Lower Bound” (ELB) which is an interest rate threshold below which monetary easing becomes contractionary. The ELB constrains the ability of monetary policy to stimulate aggregate demand, placing an upper bound on the level of output achievable through monetary stimulus.

The ELB can occur at positive interest rates and is therefore a potentially tighter constraint for monetary policy than the Zero Lower Bound (ZLB). Furthermore, global monetary and financial conditions affect the ELB and thus the ability of central banks to support the economy through monetary accommodation. A tightening in global monetary and financial conditions leads to an increase in the ELB which in turn can force domestic monetary authorities to increase policy rates in line with the empirical evidence presented…

The BIS research is focussed on emerging economies, but aspects of the ELB are evident elsewhere. The limits of monetary policy are clearly observable in Japan: the Eurozone may be entering a similar twilight zone.

The difference between emerging and developed economies response to a tightening in global monetary conditions is seen in capital flows and exchange rates. Whilst emerging market currencies tend to fall, prompting their central banks to tighten monetary conditions in defence, in developed economies the flow of returning capital from emerging market investments may actually lead to a strengthening of the exchange rate. The persistent strength of the Japanese Yen, despite moribund economic growth over the past two decades, is an example of this phenomenon.

Part of the driving force behind developed market currency strength in response to a tightening of global monetary conditions is demographic, a younger working age population borrows more, an ageing populous borrows less.

At the risk of oversimplification, lower bond yields in developing (and even developed) economies accelerate the process of capital repatriation. Japanese pensioners can hardly rely on JGBs to deliver their retirement income when yields are at the zero bound, they must accept higher risk to achieve a living income, but this makes them more likely to drawdown on investments made elsewhere when uncertainty rises. A 2% rise in US interest rates only helps the eponymous Mrs Watanabe if the Yen appreciates by less than 2% in times of stress. Japan’s pensioners face a dilemma, a fall in US rates, in response to weaker global growth, also creates an income shortfall; capital is still repatriated, simply with less vehemence than during an emerging market crisis. As I said, this is an oversimplification of a vastly more complex system, but the importance of capital flows, in a more polarised ‘risk-on, risk-off’ world, is not to be underestimated.

Returning to the BIS working paper, the authors conclude: –

The models highlight a novel inter-temporal trade-off for monetary policy since the level of the ELB is affected by the past monetary stance. Tighter ex-ante monetary conditions tend to lower the ELB and thus create more monetary space to offset possible shocks. This observation has important normative implications since it calls for keeping a somewhat tighter monetary stance when global conditions are supportive to lower the ELB in the future.

Finally, the models have rich implications for the use of alternative policy tools that can be deployed to overcome the ELB and restore monetary transmission. In particular, the presence of the ELB calls for an active use of the central bank’s balance sheet, for example through quantitative easing and foreign exchange intervention. Furthermore, the ELB provides a new rationale for capital controls and macro-prudential policies, as they can be successfully used to relax the tensions between domestic collateral constraints and capital flows. Fiscal policy can also help to overcome the ELB, while forward guidance is ineffective since the ELB increases with the expectation of looser future monetary conditions.

Conclusions and investment opportunities

The concept of the ELB is new, the focus of the BIS working paper is on its impact on emerging markets. I believe the same forces are evident in developed economies too, but the capital flows are reversed. For investors, the greatest risk of emerging market investment is posed by currency, however, each devaluation by an emerging economy inexorably weakens the position of developed economies, since the devaluation makes that country’s exports immediately more competitive.

At present the demographic forces favour repatriation during times of crisis and repatriation, at a slower rate, during times of EM currency appreciation. This is because the ageing economies of the developed world continue to drawdown on their investments. At some point this demographic effect will reverse, however, for Japan and the Eurozone this will not be before 2100. For more on the demographic deficit the 2018 Ageing Report: Europe’s population is getting older – is worth reviewing. Until demographic trends reverse, international demand to borrow in US$, Euros and Yen will remain popular. Emerging market countries will pay the occasional price for borrowing cheaply, in the form of currency depreciations.

For Europe and Japan a reckoning may be nigh, but it seems more likely that their economic importance will gradually diminish as emerging economies, with a younger working age population and higher structural growth rates, eclipse them.

Where in the world? Hunting for value in the bond market

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Macro Letter – No 99 – 22-06-2018

Where in the world? Hunting for value in the bond market

  • Few government bond markets offer a positive real return
  • Those that do tend to have high associated currency risk
  • Active management of fixed income portfolios is the only real solution
  • Italy is the only G7 country offering a real-yield greater than 1.5%

In my last Macro Letter – Italy and the repricing of European government debt – I said: –

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets.

Suffice to say, I received a barrage of advice from some of my good friends who have worked in the fixed income markets for the majority of their careers. I felt I had perhaps been flippant in dismissing an entire asset class without so much as a qualm. In this letter I distil an analysis of more than one hundred markets around the world into a short list of markets which may be worthy of further analysis.

To begin with I organised countries by their most recent inflation rate, then I added their short term interest rate and finally, where I was able to find reliable information, a 10 year yield for the government bond of each country. I then calculated the real interest rate, real yield and shape of the yield curve.

At this point I applied three criteria, firstly that the real yield should be greater than 1.5%, second, that the real interest rate should also exceed that level: and finally, that the yield curve should be more than 2% positive. These measures are not entirely arbitrary. A real return of 1.5% is below the long-run average (1.7%) for fixed income securities in the US since 1900, though not by much. For an analysis of the data, this article from Observations and Notes is informative – U.S. 10-Year Treasury Note Real Return History: –

As you might have expected, the real returns earned were consistently below the initial coupon rate. The only exceptions occur around the time of the Great Depression. During this period, because of deflation, the value of some or all of the yearly interest payments was often higher than the original coupon rate, increasing the yield. (For more on this important period see The 1929 Stock Market Crash Revisited)

While the average coupon rate/nominal return was 4.9%, the average real return was only1.7%. Not surprisingly, the 3.2% difference between the two is the average inflation experienced for the century.

As an investor I require a positive expected real return with the minimum of risk, therefore if short term interest rates offer a real return of more than 1.5% I will incline to favour a floating rate rather than a fixed rate investment. Students of von Mises and Rothbard may beg to differ perhaps; for those of you who are unfamiliar with the Austrian view of the shape of the yield curve in an unhampered market, this article by Frank Shostak – How to Interpret the Shape of the Yield Curve provides an excellent primer. Markets are not unhampered and Central Banks, at the behest of their respective governments, have, since the dawn of the modern state, had an incentive to artificially lower short-term interest rates: and, latterly, rates across the entire maturity spectrum. For more on this subject (6,000 words) I refer you to my essay for the Cobden Centre – A History of Fractional Reserve Banking – the link will take you to part one, click here for part two.

Back to this week’s analysis. I am only interested in buying 10yr government bonds of credit worthy countries, where I can obtain a real yield on 10yr maturity which exceeds 1.5%, but I also require a positive yield curve of 2%. As you may observe in the table below, my original list of 100 countries diminishes rapidly: –

Real Bond yields 1.5 and 2 percent curve

Source: Investing.com, Trading Economics, WorldBondMarkets.com

Five members of this list have negative real interest rates – Italy (the only G7 country) included. Despite the recent prolonged period of negative rates, this situation is not normal. Once rates eventually normalise, either the yield curve will flatten or 10yr yields will rise. Setting aside geopolitical risks, as a non-domicile investor, do I really want to hold the obligations of nations whose short-term real interest rates are less than 1.5%? Probably not.

Thus, I arrive at my final cut. Those markets where short-term real interest rates exceed 1.5% and the yield curve is 2% positive. Only nine countries make it onto the table and, perhaps a testament to their governments ability to raise finance, not a single developed economy makes the grade: –

REal Bond yields 1.5 and 2 pecent curve and 1.5 real IR

Source: Investing.com, Trading Economics, WorldBondMarkets.com

There are a couple of caveats. The Ukrainian 10yr yield is derived, I therefore doubt its accuracy. 3yr Ukrainian bonds yield 16.83% and the yield curve is mildly inverted relative to official short-term rates. Brazilian bonds might look tempting, but it is important to remember that its currency, the Real, has declined by 14% against the US$ since January. The Indonesian Rupiah has been more stable, losing less than 3% this year, but, seen in the context of the move since 2012, during which time the currency has lost 35% of its purchasing power, Indonesian bonds cannot but considered ‘risk-free’. I could go on – each of these markets has lesser or greater currency risk.

I recant. For the long term investor there are bond markets which are worth consideration, but, setting aside access, liquidity and the uncertainty of exchange controls, they all require active currency management, which will inevitably reduce the expected return, due to factors such as the negative carry entailed in hedging.

Conclusions and investment opportunities

Investing in bond markets should be approached from a fundamental or technical perspective using strategies such as value or momentum. Since February 2012 Greek 10yr yields have fallen from a high of 41.77% to a low of 3.63%, although from the July 2014 low of 5.47% they rose to 19.44% in July 2015, before falling to recent lows in January of this year. For a trend following strategy, this move has presented abundant opportunity – it increases further if the strategy allows the investor to be short as well as long. Compare Greek bonds with Japanese 10yr JGBs which, over the same period, have fallen in yield from 1.02 in January 2012 to a low of -0.29% in July 2016. That is still a clear trend, although the current BoJ policy of yield curve control have created a roughly 10bp straight-jacket beyond which the central bank is committed to intervene. The value investor can still buy at zero and sell at 10bp – if you trust the resolve of the BoJ – it is likely to be profitable.

The idea of buying bonds and holding them to maturity may be profitable on occasion, but active management is the only logical approach in the current global environment, especially if one hopes to achieve acceptable real returns.