LIBOR Is Out, SOFR Is in – What It Means
This article was published in October 2019 but hopefully it may still be useful, especially in these volatile times.
LIBOR Is Out, SOFR Is in – What It Means
This article was published in October 2019 but hopefully it may still be useful, especially in these volatile times.
Macro Letter – No 127 – 13-03-2020
Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective
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:-
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.
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: –
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: –
Source: Trading Economics
Everywhere GDP forecasts are being revised lower: –
For the world’s governments there are essentially three policy responses: –
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: –
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: –
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: –
Source: Federal Reserve Bank of St Louis
US 10 year Treasury Bonds simply reflected the actions of the Federal Reserve: –
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.
Macro Letter – No 124 – 20-12-2019
The Beginning of the End of Uncertainty for the UK
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 Profit – risk 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: –
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: –
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: –
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: –
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: –
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: –
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: –
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: –
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): –
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: –
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.
Macro Letter – No 123 – 29-11-2019
Leveraged Loans – History Rhyming?
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.
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 $40 billion pile of leveraged loans is battered by big losses – the loans of more than 50 companies have seen their prices decline by more than 10%. The slowing economy appears to be the culprit, credit rating agencies are, as always, reactive rather than proactive, so the risk that many CLOs may soon cease to be investment grade is prompting further selling, despite the absence of actual credit downgrades. The table below shows magnitude of the problem as at the beginning of last month: –
It is generally agreed that the notional outstanding issuance of US$ 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: –
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: –
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: –
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: –
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.
In this second AIER article I look at the wider implications of negative interest rates.
To read the previous article, please click here
This is the first of two articles about negative real interest rates.
Macro Letter – No 117 – 28-06-2019
Interest Rates, Global Value Chains and Bank Reserve Requirements
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: –
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): –
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: –
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.