Tuesday, 23 September 2014

Credit - Wall of Voodoo

"It is enough that the people know there was an election. The people who cast the votes decide nothing. The people who count the votes decide everything." - Joseph Stalin

Apologies dear readers for the lack of posting recently but, we have been enjoying some R&R, giving us plenty of time to catch up with family and friends as well as keeping an curious eye on the series of eventful news that made the headline such as French former president Sarkozy's return to politics (or the return of the comeback kid) and of course the results of the much feared Scottish referendum (hence our tongue-in-cheek quote from above). But, regarding our latest chosen title, you might wonder why we have chosen such a reference. One of our good friends and fellow "Macronomics" blogger and reader really enjoyed our most recent musical reference and challenged us to come up with some more. We felt obliged to comply with his request and decided to steer towards American New Wave 80s group Wall of Voodoo, known for their 1983 hit "Mexican Radio". Of course as always, there is indeed a dual reference in our chosen title given the 80s saw as well the emergence of "voodoo economics" also called Reaganomics, commonly associated with supply-side economics, leading to a rapid surge in the US dollar, the Latin American crisis and the infamous market crash of 1987. The four pillars of this policy were as follows: reduction of the growth of government spending, reduction of the federal income tax and capital gains tax, reduction of government regulation, and tightening of the money supply in order to reduce inflation.

You might wonder where we are going with our analogy but we see many similarities in the US economic situation under Reaganomics with some of the economic results triggered by both the Obama administration and the expansionary monetary policies of the Fed of today. In similar fashion to the Reagan era, political pressure indeed favored stimulus resulting in an expansion of the money supply. Also, under Reagan the public debt rose from 26% to GDP in 1980 to 41% of GDP by 1988, a roughly three fold increase. The unemployment rate under Reagan rose from 7% in 1980 to 10.8% in 1982, and then declined to 5.4% in 1988. Of course during the current Obama administration, the recovery has been less than formidable in the job creation space. The rate of growth of real GDP under Reagan averaged 3.05% with real median median family income growing by $4000 during the "Voodoo" period which has not been the case presently. During the Reagan administration, federal receipts grew from $618 billion to $991 billion (an increase of 60%); while outlays grew from $746 billion to $1144 billion (an increase of 53%).

For comparative purposes we looked at the receipts and deficits under both administration as published by the US Office of Management and Budget:
- source Macronomics - Office of Management and Budget

What is interesting in the above table for both "Reaganomics" and "Obanomics" have been the increases in tax receipts under both administrations in conjunction. But, there has been a rapid decline in the budget deficit in the case of the Obama administration, whereas, under Reagan, the deficit was roughly stable. In both cases there was a rapid surge in public debt.

As we pointed out in our last conversation, we are getting increasingly concerned on the potential impact the velocity in the rise of the US dollar could have on "exposed" Emerging Markets sovereign and corporates in particular in Latin America:
"External funding requirements of EM economies remain heavily skewed to USD denominated funding."

Therefore in this week conversation we will look again at the increasing risks posed by the velocity in the surge of the US dollar which could lead to wave number three namely a currency crisis (as a reminder):
"We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":
"If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
We will also look at US High Yield which is becoming increasingly a crowded traded and is losing its appeal.

Given Wall of Voodoo's hit was 1983's Mexican Radio, we find it amusing that it followed the debt crisis of 1982 which was the most serious in Latin America's history. The contraction of world trade in 1981 followed the rise in interest rates in both the United States and Europe in 1979.  Today we are seeing another fall in commodities prices (iron ore, copper, oil, etc). In August 1982, Finance Minister Jesus Silva-Herzog declared Mexico would no longer be able to service its debt:
"I'm on a mexican radio. I'm on a Mexican - whoah - radio

I dial it in and tune the station
They talk about the U.S. inflation
I understand just a little
No comprende, it's a riddle" - Source Wall of Voodoo - Mexican Radio lyrics extract

From our perspective and given never before in the post-Bretton Woods era of floating exchange rates had the trade-weighted ICE dollar index risen for 10 consecutive weeks as it did in the most recent 10 weeks ending on Friday, we are indeed thinking about the "Wall of Voodoo", namely the risk of a currency crisis due to dollar scarcity which could trigger a "new wave" of defaults à la 80s fashion hence our chosen title.

The evolution of the ICE index, known by its ticker DXY and based on a weighted basket of six other currencies – the euro, yen, sterling, Swiss franc, Swedish krona and Canadian dollar - graph source Bloomberg:

And the long view on the DXY - graph source Bloomberg:
The DXY index was founded in 1973, when the Bretton Woods system formally ended, and it has been reweighted only once, to make room for the introduction of the euro in 1999.

As indicated by Société Générale in their latest Multi-Asset Portfolio review, the US Dollar is indeed striking back:
"The Federal Reserve is clearly indicating that an exit from the zero-rate policy could materialise before mid-year 2015. Another effect of the market pricing the Federal Reserve monetary policy outlook is a reinforced US dollar. The rise in short-term rates this year supported the dollar across the board. This was visible in USD/JPY, and in particular in EUR/USD, helped by the dovish ECB." - source Société Générale

Of course what it appears to us to be the upcoming change in the markets is a "regime change" in the volatility space and most particularly in the FX space. If the European markets continue its "Japanification" process, one can expect indeed an increasing rise in currency volatility as witnessed during Japan's deflation episode leading USD/JPY to become one of the most volatile currency pair in the Forex space.

We think the low volatility regime is indeed coming to an end and while it can be ascertained from the FX and Rates space, it has yet to translate into the equity sphere. Rest assured it will happen. On that note we do agree with Société Générale's take from their latest note:
"There is no contagion into equity markets yet. We expect the market pricing of the Fed tightening to be the trigger for putting equity volatility regime under pressure.
We expect the move to accelerate in equities as well as some point as the market prices in US tightening"
- source Société Générale

Of course the regime change and our "Wall of Voodoo" as the song goes, means that we are indeed dialing in and tuning to the "Mexican radio", meaning that as far as the US household income/corporate margin tradeoff is concerned, we think going forward US equities will start feeling the heat ("The Heat is On" is yet another 80s hit from the 1984 American film Beverly Hills Cop but we ramble again). In terms of the "Wall of Voodoo" we previously stated that our biggest concern was indeed the "profit cliff", a subject we discussed back in 2012 in our conversation "The Omnipotence paradox":
"Moving on to the subject of the risk of the "Profits Cliff", we believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook as we moved towards 2013. As we discussed in June in "River of No Returns", 56.5% of discretionary stock have a Beta greater than 1.1 and consensus for 2013 were the highest in discretionary stocks. We quoted Morgan Stanley's research note at the time of this conversation: "Earnings, like trees, don't grow to the sky"."

On that specific subject of US corporate profit margin, this is further illustrated by Nomura in their latest Global Equity Strategy note from the 19th of September entitled "Take my punchbowl away please":
"US household income/corporate margin tradeoff. However, falling unemployment and rising US wage inflation would also begin to erode historically high US corporate profit margins (Figure 9). 
With this, the pace of US earnings upgrades would almost certainly slow from the standout 7.0% YTD pace noted above. Thus our preliminary end-2015 S&P 500 index target (of 2,200) implies “only” single-digit upside next year – meaning ironically the best way to play the rise in US household incomes and consumption may be through non-US markets with high export-intensity to the US consumer." - source Nomura

From a "valuation" point of view, the underloved European markets appears to us more attractive from a contrarian approach than the US markets currently. When it comes to Emerging Markets equity exposure, our preferences continue to go towards Emerging Asia.

Given credit investors are anticipatory in nature, in 2008-2009, credit spreads started to rise well in advance (9 months) of the eventual risk of defaults, bringing us to our second subject of our post being the rapidly fading attractiveness of US High Yield.

On that subject, we agree with Bank of America Merrill Lynch recent take on the subject of default from their latest  High Yield Wire note from the 23rd of September entitled "The next default wave: Slow and Low":
Default wave to resemble late ‘90s, early ‘00s
"We believe the next default cycle is likely to resemble that of the late 1990s and early 2000s, marked by two waves and in acute sectors. We envision a scenario where current distressed firms cause the default rate to rise in 2015 which, when coupled with a rise in treasury yields, leads to a retail driven downturn in high yield bonds and a further unwillingness to lend to stretched corporates in 2016. This combination of events does not freeze capital markets, but rather creates a slow drain of liquidity from corporate issuers that were able to get financing from 2010-2014. Additionally, with stringent rules around bank lending standards, significant existing covenant-lite issuance, and what we believe will be an increase in the size and scope of non-regulated lenders, the turn of this credit cycle may be one that in many ways is unlike any we have seen before. In particular, we envision an environment that is characterized by a lower default rate but an increased numberof what we call ‘zombie companies’." - source Bank of America Merrill Lynch

In this note they also added the following:
"Generally speaking, defaults don’t pick up while interest rates are increasing (notwithstanding the first round of defaults in the late 1990s – a topic we’ll discuss more below). Given the fact that the economy was already headed in a downward trajectory during past cycles, the Fed typically has already started cutting rates and treasury yields have declined by the time defaults increase substantially.
Party like its 1999
This situation could bear some resemblance to what we expect to see in 2015 and 2016. In the below chart we see that in 1999 defaults of stressed names caused the default rate of the overall market to increase. 
Despite a subsequent drop in the default rate of these issuers, however, the overall default rate remained modestly elevated at about 5.5% for 2 years before picking up again substantially in 2001. What is extraordinary about this period is that the defaults of distressed companies didn’t immediately lead to a spike in the overall default rate like during the last crisis. This is in large part because the overall economy was strong; the initial spike was caused by companies already in trouble, while the slow bleed that followed was due to shaky balance sheets after an aggressive telecom infrastructure build during the mid-1990s.
Contrast this default pattern with what we expect to see over the next two years. The distressed defaults of the 1990s could be today’s well known troubled retail names, rather than the worst-off CLECs, and are likely to fall into bankruptcy despite strong economic growth. The effect of the increase in defaults will likely be met at first with an air of inevitability. After all, most investors now expect that RadioShack, Sears, JC Penny and others will experience serious headwinds as going concerns in the relatively near future. To this end, we believe the first couple of defaults are unlikely to shake the market substantially. However, we do fear that as 2 bankruptcies turns to 3, and 3 to 4, that the headlines of the events will begin to scare retail investors in particular. Although this process may take 6, 9 or even 12 months, as the default rate begins to tick higher, rates begin to increase and total returns are lackluster, we believe retail investors will begin to put pressure on high yield, affecting both the secondary and primary marketsAs mentioned above, we don’t believe this potential weakness leads to a rash of defaults and expect non-retail investors to support the market at first. However, we also believe fatigue will eventually set in as large institutions become more discerning of the new issue market. As 2015 turns to 2016, rates are higher and retail is less interested in the asset class as the carry trade slowly unwinds itself, we believe the institutional buyer base will be less willing to lend or extend credit to companies that haven’t shown a clear ability to grow or generate positive free cash flow. In particular first-time issuers or those issuers that first came to market over the last several years could represent a problem during this time. We are most concerned with CLEC-type companies: those issuers who have recently come to market with little to no financial information available, no Wall Street analyst coverage, and negative free-cash flow.
In our view, it is a combination of events that will lead to the increase in defaults, and a first sign among them is the response of retail investors to deteriorating credit quality. This summer’s selloff, in our view, provides an interesting case study of the impact retail can have to the market"

We agree with the above and the recent turmoil surrounding UK issuer Phone4U highlight the risk of rapid of decline in high yields prices in the market in conjunction with low recovery rate that can be ascertained from this particular example. In the case of Phone4U, BC Partners, the private equity owner of the business had GBP 480 million of senior bonds outstanding maturing in 2018 issued by Phone4U Finance. These senior bonds in a matter of days fell from par to around 10 to 15 pence in the pound highlighting the very low recovery of the senior bonds. When it comes to subordinated bondholders of PIK-toggle note issued by Phosphorus Holdco, they face the risk of total wipe-out. So much for picking 600 bps more than the senior in the first place...

While visiting friends and family in Paris, we had an interesting lunch with a French friend who appears to be a corporate LBO originator banker. While the French model is different than in the US in the sense that French banks retain some of the risk on the balance sheet rather than originate and distribute like some of their US counterparts do, he confirmed to us the firmness of the market and the appetite for risk. For instance whereas some banks are refusing some leveraged deals, the current ZIRP environment is indeed pushing deals being done by non-regulated lenders with investors clearly going outside their comfort zone and disregarding the risks presented by some deals having zero equity buffers in the first place.

On that particular note, Bank of America Merrill Lynch in their High Yield note highlight a significant rise in the role played by non-regulated lenders in the Cov-lite space:
"Zombie Apocalypse: Cov-lite and non-regulated lenders
We have written in the past about cov-lite issuance and the fact that cov-lite loans have a lower cumulative default rate than traditional loans as the ability to have financial flexibility seems to help during times of distress. However, given new Fed and OCC letters to the large, regulated US investment banks about their lending practices and restrictions on leverage (in particular, those issuers with leveraged greater than 6x), we believe cov-lite issuance could prove to be a problem in years to come as new deals are pushed off to non-regulated lenders. We envision an environment where stressed companies turn to non-regulated entities to complete deals that would traditionally be underwritten by the large investment banks. Many of these deals may be small club deals arranged by private equity firms or hedge funds. Others may be loan to own deals while yet more may be fully syndicated to investors. However, we believe these lenders are likely to be more predatory than their regulated counterparts- potentially layering more debt than the business model can withstand or with higher rates than would otherwise be desirable. PE firms currently have over $400bn2 in dry powder and have shown their willingness and desire to build capital market franchises while boutique shops outside of the purview of the Fed and OCC have increased substantially. In fact, according to league tables from Bloomberg, in 2007 41 companies underwrote leveraged loan deals while year-to-date 87 different firms have underwritten deals. Of the 87 different firms, a large number fall outside the
scope of the OCC and the Fed. For example, Jeffries and KKR are two firms that combined have underwritten more than $10bn in leveraged loans so far in 2014 and S&P Capital IQ LCD estimate that 83% of total middle market volume was from non-bank lenders in 2013, up from 71% in 2011.
Our fear is that as more non-regulated lenders extend increasing amounts of credit to risky borrowers, existing debt holders are likely to come out on the bottom given current loose covenants. We note in Chart 10 that as a percentage of market size, 50% of all loan issuance was cov-lite over the last 12 months.
Where this could prove to be a problem is as borrowers who issued loans in the last several years need to come back to the market, non-regulated lenders may have the ability to hurt existing holders of the debt by being a lender of last resort. We see this potential as a consequence of higher rates, lower retail and institutional demand given quality and return concerns, and increased bank regulation. This is yet another reason why the default rate may not increase dramatically over the next couple of years while zombie companies displace defaulted entities." - source Bank of America Merrill Lynch

Of course the "Wall of Voodoo" and our rising concerns US High Yield wise being less and less appealing comes from the rise in first time issuers and the decrease in both credit quality and transparency when it comes to company fundamentals as highlighted by Bank of America Merrill Lynch:
"First concern, first time issuers
Since 2009 over 600 companies have issued debt for the first time. Though in isolation we don’t think this is a cause for alarm, when coupled with the decrease in quality and coupon of these issuers relative to past periods as well as the lack of transparency surrounding company fundamentals, we believe these issuers can be the driving force behind a long, slow beginning to the next default wave. Chart 11 below shows that the average rating of first time issuers has decreased relative to all new issues over the last couple of years (the higher the numeric rating, the worse the quality) 

while Chart 12 highlights the drop in coupon of first time issuers relative to all new issues.
Even more dramatic is to look at the decrease in first time issuer’s coupons relative to the increase in numeric rating in Chart 13. 
As the quality of first time issuers has declined so has coupon, a phenomenon that is inconsistent with any other period over the last decade. What is most concerning about all of these statistics is that the number of issuers that have a history of financial statements available (in Bloomberg) at the time of their issuance has plummeted (Chart 14). 
This suggests to us that investors have not been able to perform the necessary homework to justify lending to many of these companies. So far in 2014, just 8% of all first time issuers have financial statements in Bloomberg prior to issuance.
Within our set of first time issuers we further breakdown the cohort by rating. Our findings suggest that CCC first time issuers have been pricing tight to all triple C new issue paper while the market currently demands a premium for first time single B and double B issuers (Chart 11). The low coupons of first time CCC issuers bode well for the immediate future of these companies. The lower interest expenses, in our view, will further prolong the credit cycle until the first wave of highly distressed companies noted above realize their eventual demise. However, as investors become more critical of lending terms and as rates increase throughout 2015, we also believe such low financing could prove detrimental when these companies need to refinance existing debt in 2016 and 2017 from given what appears to be relatively weak credit fundamentals." - source Bank of America Merrill Lynch

Of course we were way in advance in sounding a warning on that subject in our conversation "The False Alarm" in October 2013 where we stated:
"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics

We were indeed right in our 2013 assertion as it was validated by Bank of America Merrill Lynch's note:
"Deteriorating fundamentals of first time issuers
Based on the information we do have about first time issuers, we are also concerned about their fundamentals. Free cash flow among first time issuers is seems to be very poor. Over 40% (66 out of 162) of all first time issuers since the crisis where we have data have negative free cash flow. Filtering on this universe, we see 15 of these issuers are currently rated triple C, all but one has been issued since 2010 and 13 of the 15 are Energy names. 43 of the issuers with negative free cash flow are rated single B, and of these issuers, 21 are energy names. While we believe many of these first time issuers will be targets for M&A in 2015 we also believe that many will find it difficult to survive rising rates, heightened fundamental scrutiny and tighter bank regulations.
However, first time issuers are not our only concern when it comes to new issuance as the entire new issue market has become lower quality based on fundamentals. For example, since 2004 net leverage for all new issues has increased to nearly 5x, well above the average leverage of our index of 3.8x.
Additionally, triple C issuance has increased substantially since the crisis, as the last 12 months of CCC issuance is equal to nearly 50% of all the CCC issuance currently outstanding. What worries us is that in a period where rates rise and credit quality concerns are more at the fore of investors’ minds, that many of these issuers will find it difficult to tap the bond market." - source Bank of America Merrill Lynch

So we will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

As we stated in our 2013 conversation, we have continued to dance to "Wall of Voodoo" and their "Mexican Radio", but we have been quietly moving closer towards the exit door.

On a final note, we leave you with Société Générale's latest take on US High Yield being more and more in the over-valuation territory. Given the difference in terms of cycle as displayed in our last conversation, we do prefer European credit to that effect but, that is another story...

"In the simplest terms, inflation occurs when there's too much money in the system. On the flip side, deflation occurs when there are too few dollars in circulation." - Robert Kiyosaki, American author.

Stay tuned!

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