Wednesday, 31 October 2018

Macro and Credit - Explosive cyclogenesis

"Invincibility lies in the defence; the possibility of victory in the attack." - Sun Tzu

Looking at the bloodbath occurring in various sectors of the US equity markets during the scary month of October historically for financial markets such as the Black Monday of October 16th 1987, when it came to selecting this week title analogy, we decided to go towards a meteorological analogy, namely "Explosive cyclogenesis".  "Explosive cyclogenesis" is also referred as a weather bomb. The change in pressure needed to classify something as explosive cyclogenesis is latitude dependent. For example, at 60° latitude, explosive cyclogenesis occurs if the central pressure decreases by 24 mbar (hPa) or more in 24 hours. Given the velocity in which US "real rates accelerated upwards at the beginning of the month in conjunction with the surge of the balance sheet reduction of the US Fed to $50 billion per month. The Fed’s QE Unwind Reaches $285 Billion From the 6th of September through the 3rd of October, the Fed’s holdings of Treasury Securities fell by $19 billion to $2,294 billion, the lowest since March 5, 2014. Given an explosive cyclogenesis occurs if the central pressure decreases rapidly, in similar fashion, the acceleration in the Fed's reduction of its balance sheet triggered the "weather bomb" on financial markets. 

Many pundits have been reminding themselves of Black Monday given it occurred during the month of October as well. Many have forgotten the Great Storm of 1987 which was a violent extratropical cyclone that occurred on the night of 15-16th of October. That day's weather reports failed to indicate a storm of such severity, an earlier, correct forecast having been negated by later projections. On the Sunday before the storm struck, the farmers' forecast had predicted bad weather on the following Thursday or Friday, 15–16 October. By midweek, however, guidance from weather prediction models was somewhat equivocal. Instead of stormy weather over a considerable part of the UK, the models suggested that severe weather would reach no farther north than the English Channel and coastal parts of southern England. At 2235 UTC, winds of Force 10 were forecast. By midnight, the depression was over the western English Channel, and its central pressure was 953 mb. At 0140 on 16 October, warnings of Force 11 were issued. The depression now moved rapidly north-east, filling a little as it did, reaching the Humber Estuary at about 0530 UTC, by which time its central pressure was 959 mb. Dramatic increases in temperature were associated with the passage of the storm's warm front. During the evening of 15 October, radio and TV forecasts mentioned strong winds, but indicated that heavy rain would be the main feature, rather than wind. By the time most people went to bed, exceptionally strong winds had not been mentioned in national radio and TV weather broadcasts. The storm cost the insurance industry GBP 2 billion, making it the second most expensive UK weather event on record to insurers after the Burns' Day Storm of 1990. 

Following the storm few dealers made it to their desks and stock market trading was suspended twice and the market closed early at 12.30pm. The disruption meant the City was unable to respond to the late dealings at the beginning of the Wall Street fall-out on Friday 16 October, when the Dow Jones Industrial Average recorded its biggest-ever one-day slide at the time, a fall of 108.36. City traders and investors spent the weekend, 17–18 October, repairing damaged gardens in between trying to guess market reaction and assessing the damage. The 19th of October, Black Monday, was memorable as being the first business day of the London markets after the Great Storm. The trigger for the "weather bomb" in early October which led to a 10% mini-crash was a warning by Fed chairman Jay Powell that the Fed planned to push interest above the "neutral rate" to prevent overheating. So, central pressure fell rapidly, real rates shoot up and the rest is as we say history but, we ramble again.

In this week's conversation, we would like to look at the buildup in recession signs we are seeing adding to the "reflexivity" in the tightening of financial conditions. Are the "weather" forecasts of no recession in sight justified? We wonder.

  • Macro and Credit -  "Reflexivity" and Recessions
  • Final charts -  Where is the "credit" weather bomb?

  • Macro and Credit -  "Reflexivity" and Recessions

As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks. As pointed out on Twitter by Tiho Brkan displaying a chart from JP Morgan , almost all asset classes have negative YTD returns (first time in 40 years).:
- graph source JP Morgan, H/T Tiho Brkan

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".

The rise in “real rates” triggered repricing of forward EPS, and forced investors to mark a lower strike to the Fed “put”.  Real rates grew at the same pace as 12 months Forward EPS until the “repricing”:
- graph source Macrobond

Given financial markets should act for many investorss as a "discounting mechanism", no wonder, with liquidity being removed thanks to QT, markets have had to "reprice" forward EPS accordingly in such a short period of time. The US markets have been defying gravity way too long and their outperformance versus the rest of the world has been significant in 2018.

When it comes to "buying the dip", Merryn Somerset Webb in the Financial Times makes some interesting comments:
"October shouldn’t be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors perhaps) this is nasty. For the rest of us it is good news, twice over.
First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40 per cent of S&P 500 companies have reported in this earnings season and some 80 per cent of them have managed to produce a positive surprise. Digitalisation may well be about to transform productivity in developed economies. And there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)
Second, stock markets outside the US really are not that expensive anymore and pockets of them are beginning to look like they offer some value. That should please long-term investors.
It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for." - source Financial Times - Merryn Somerset Webb 
In terms of "cheap" market outside the US, and as pointed out in her article as well, apart from the United States, Russia regardless of US sanctions, was left pretty much unscathed relative to other Emerging Markets. Russia, equity market should be priced for a continued rebound. Forget the sanctions, rising oil prices could be very supportive and with a PE of around 5.2, you have very limited downside. The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors; given the extreme volatility of American politics (and thus sanctions). Comparing Eurobond yields with Russian equity yields for the same risks will show you more "arbitrage" opportunities so we suggest you do your homework on this...

But, for sure, with rising dispersion, active management as pointed out by Merryn Somerset Webb  should come back into play, given the growing rotation between value and growth:

- source Thomson Reuters Datastream - H/T Holger Zschaeptiz on Twitter.

The growth trade over value trade is over. That’s your "great rotation" from "growth" to value" in one chart…

Moving back to the "main course" namely "Reflexivity" and Recession, we do believe that we have passed "peak" consumer confidence in the US. For instance the University of Michigan’s consumer sentiment index fell from 100.1 in September to 98.6 in October. This we think was “peak” consumer confidence with cyclicals such as Housing and Autos becoming a headwind for the US consumer.

Sure US Q3 GDP came at an annualized 3.5% but, it is because Americans save less to sustain spending as income gains cool. Americans saved 6.2% of their disposable income matching the lowest level since 2013:
- graph source Bloomberg

On top of that we can list the following "headwinds":
  • Investors are selling the shares that hit quarterly earnings expectations at the highest rate since 2011. Good times are behind us…
  • Early indicators show that economic conditions continue to weaken in China
  • Residential investment fell 4% marking the third straight quarterly decline. That hasn’t happened since late 2008 and early 2009.
  • Breaking bad? Even equity-long short hedge funds could see their worst month since the Great Financial Crisis (GFC). August 2011 level reached so far.
  • U.S. investment-grade bond funds reported $1.6 billion in outflows in the past week, the fourth consecutive withdrawal for total redemptions of $7.2 billion; HY funds reported $2.1 billion of outflows according to Wells Fargo Securities.
We could also add David P Goldman's recent comments in Asia Times that US consumer discretionary stocks have been propped up by credit card binge:
"Consumer discretionary stocks have outperformed the S&P 500 by about 10% during the past year. That may be about to change.
Consumer spending remains robust in the United States according to this morning’s US data release. Personal spending was up 0.4% in September, or a 5% annual rate. The problem is that personal income rose only 0.2%, or a 2.4% annual rate.
Consumers are spending more than they earn. The past year’s pop in consumer spending depended on credit cards. That’s not a sustainable situation.
The chart below shows three-month changes in US retail sales vs. three-month changes in credit card debt outstanding. During the past year, the two lines look nearly identical.

Here’s another way to measure the dependence of retail sales on credit cards: The six-month rolling correlation between monthly changes in retail sales and monthly changes in credit card balances outstanding has risen to about 70%.
- source David P Goldman - Asia Times
US consumers might not be “buying the dip” but, are dipping into their savings to “sustain” their consumption and that's something to worry about. We haven't even much growth deceleration in Europe at this stage. We recently mused around shipping indicative of a slowdown in global trade in our latest conversation "Ballyhoo" and the Harpex index as an indicator.

Apart from the clear underperformance of the exported oriented German Dax Index or the Korean Index, Anastasios Avgeriou, Chief Equity Strategist at BCA Research pointed out on Linkedin today a very interesting chart:
"Who would have thought that the DAX and chip stocks are more or less the same trade... Both are very sensitive to global growth and thus interest rates. In other words, rising interest rates hurts them, and vice versa..." - source Anastasios Avgeriou, Chief Equity Strategist at BCA Research 
Misery do loves company one would argue. Cyclicals such as housing, autos and even chips have been impacted by the deceleration in global trade hence the latest weakness seen in Europe from slower GDP growth. 

As well there are some other signs pointing towards trouble at a later stage, which will follow the "relief" rally we are seeing. 

For instance, as pointed by the IIF, despite stronger earnings growth this year, many US companies struggle with debt service:
"Many companies are not generating enough earnings to cover interest expenses - despite still strong earnings growth. With growth expected to slow in 2019 and rates still rising, the problem could get worse" - source IIF
In our book credit leads equity and we are closely watching credit drifting wider thanks to the Fed tightening slowly but surely the credit noose as can be seen in the below Bloomberg chart posted by Lisa Abramowicz on her Twitter feed:
"Yields on US High Yield bonds with CCC ratings just climbed above 10%, the highest level since the end of 2016" - source Bloomberg - Lisa Abramowicz on Twitter

Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket.
And of course the problem is getting worse given rates have been rising in-line with improving growth estimates as per the below chart from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

If indeed growth is slowing, then again the US Treasury Notes yield should be falling as well. It is difficult to play it at the moment given the rise in issuance by the US Treasury.

When it comes to "Smart Money" some have already been heading towards the exit as pointed out by Eric Pomboy on Twitter with the below Bloomberg chart:
- graph source Bloomberg - Eric Pomboy on Twitter

Someone is clearly not waiting for the explosion of the "weather bomb" it seems...

One thing for sure, the October "Explosive cyclogenesis" aka weather bomb was another warning shot by the Fed but it seems no one was really listening. This effectively means that the Fed’s strike price for US stocks is much lower as it has removed the reference to monetary policy being accommodative. This is pointed out by Morgan Stanley in their Global Interest Rate Strategist note from the 26th of October entitled "The Financial Conditions Jackpot":
"FOMC participants have been clear that the outlook for the hiking cycle is unlikely to shift simply because of equity market volatility. This sort of guidance led to interest rate vol lagging the sharp rise in equity vol. We think this is justified by fundamentals and do not yet recommend buying shorter expiry interest rate options outright. Only when the narrative of FOMC participants starts to shift will we consider paying theta. And when that occurs, we expect short-tail vol to outperform long-tail vol.
A long way to neutral?
Exhibit 47 illustrates how 1m10y vol has been lagging the spike in the VIX.

This is true of rates vol in general, which has underperformed equity vol in both realized and implied terms. We believe the main driver of this dissociation has been the general dismissal by most FOMC participants of the volatility seen in the stock market. This is an excerpt from the Q&A that followed the September FOMC press conference (our emphasis):
CHAIRMAN POWELL. So I don’t comment on the appropriateness of the level of stock prices. I can say that by some valuation measures, they’re in the upper range of their historical value ranges. But, you know, I wouldn’t want to—I wouldn’t want to speculate about what the consequences of a market correction should be. You know, we would—we would look very carefully at the nature of it, and I mean, it—really— really what hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that’s a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that’s a really bad situation. A simple drop in equity prices is— all by itself, doesn’t really have those features. It could certainly feature—it could certainly affect consumption and have a negative effect on the economy, though.
More recent comments from FOMC participants echoed that sentiment, despite the S&P 500 index being 10% off the highs. In effect, this implied that the Fed is not close to stepping in to support the stock market by altering the path for monetary policy. In other words, the so-called "Fed Put" is still out of the money. This is likely to maintain some certainty in the rates market as to the path for rates in the near term as the Fed seems set to at least reach its estimate of neutral.
Less uncertainty about rates begets lower vol. Of course, rates are still going to see higher vol in a risk-off move as a result of investment flows as well as shifting probabilities surrounding the outlook for the Fed. But our view is that this volatility will not be both sustainable and notable until the Fed Put is in the money." - source Morgan Stanley
Until the Fed Put is in the money, that is until the weather bomb has been digested by the market in similar fashion to the rapid storm experienced back in October 1987.

While many pundits are still reeling from the "bloody" October, and many are asking themselves where trouble is brewing, we do believe that some parts of US credit markets do contain some potential "weather" bombs as per our final charts below

  • Final charts -  Where is the "credit" weather bomb?
Credit always leads equities in our book when eventually we will have a definitive turn of the credit cycle. For storm chasers out there, we believe that some parts of US Credit Markets are showing signs of fragility, and it's not only the fall in quality of Investment Grade Credit. Our final charts comes from Wells Fargo Economics Group note from the 29th of October entitled "Which Sectors Have Driven Business Sector Debt Growth" and shows that the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector:
"Business Sector Debt Is Up By Nearly $5 Trillion
In a recent report, we noted that the financial health of the U.S. non-financial corporate (NFC) sector has deteriorated, at least at the margin, in recent quarters. For example, the debt-to-GDP ratio of the NFC sector has trended up to its highest level in decades (below chart).

Not only do non-financial corporations borrow from financial institutions such as banks, but they also issue bonds in the corporate debt market. In that regard, the market value of investment grade (IG) corporate bonds has shot up from less than $2 trillion during the depths of the financial crisis to more than $5 trillion today. The value of high yield (HY) corporate bonds has mushroomed from about $400 billion in late 2008 to nearly $1.3 trillion today.
The value of corporate bonds outstanding—IG and HY—has plateaued in recent months. But, lending by commercial banks to the NFC sector continues to trend higher. Indeed, the amount of leveraged loans outstanding has grown to almost $1.1 trillion at present from about $800 in early 2016 (below chart).

In total, the value of corporate bonds (IG and HY) and leveraged loans outstanding has risen by nearly $5 trillion, which is an increase of roughly 180%, since late 2008. Is this growth in corporate debt a widespread phenomenon or does it reflect higher debt loads in just a few sectors?
We disaggregated the business sector into 11 broad subsectors, and we find that debt has increased in each of these subsectors over the past 10 years (bottom chart). So the increase in business sector debt has been generally widespread. But, not every subsector has had the same experience in terms of debt growth. The financial sector leads the pack with an absolute increase in debt outstanding in excess of $1 trillion over the past ten years (horizontal axis in bottom chart).

Although the financial sector is the largest sector in terms of total debt outstanding ($1.8 trillion in Q3-2018, which is denoted by the size of the bubble), its 132% rise in outstanding debt places it below the average in terms of debt growth over the past 10 years (vertical axis). Other subsectors with slower-than-average debt growth since Q4-2008 include utilities, transportation, basic industries, consumer cyclicals and communications.
There are three subsectors that stand out in terms of debt growth over the past 10 years. The debt in the non-cyclical consumer goods industry, which includes food & beverage, healthcare and pharmaceuticals, has experienced a 275% increase in debt outstanding to $1.2 trillion at present. Energy (400% increase to nearly $700 billion) and technology (almost 600% to roughly $650 billion) are also notable for the debt growth they have experienced. In sum, most business sectors have experienced rising levels of debt over the past 10 years, but the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector." - source Wells Fargo
So there you have it, given Tech is under pressure, the energy sector is depending on the trajectory of oil prices to stay afloat (see our above point relating to interest expenses coverage) and consumer goods are depending on a more and more fragile US consumer, you can probably think that there is indeed an Explosive cyclogenesis in the making...Happy Halloween!

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore." - Vincent Van Gogh
Stay tuned !

Wednesday, 24 October 2018

Macro and Credit - Ballyhoo

"Chaos is inherent in all compounded things. Strive on with diligence." - Buddha

Watching with interest recent market gyrations, with the intervention of China in the mix to calm down the turmoil in its equities market, when it came to selecting this week's title analogy, we decided to go for the word "Ballyhoo":
  1. : a noisy attention-getting demonstration or talk
  2. : flamboyant, exaggerated, or sensational promotion or publicity
  3. : excited commotion

A "Ballyhoo" is as well a "publicity, hype" from circus slang, "a short sample of a sideshow" used to lure customers (1901), which is of unknown origin. The word seems to have been in use in various colloquial senses in the 1890s.  In nautical lingo, ballahou or ballahoo (1867, perhaps 1836) was a sailor's contemptuous word for any vessel they disliked. There is as well a 2009 book entitled "Heroes and Ballyhoo" by Michael K. Bohn about sports stars during the period 1919-30s an "era of wonderful nonsense", when sport-crazed public demanded spectacles instead of just matches. Given this golden crazy age lasted 12 years long and many pundits are indicating that a recession in the United States could happen in the next two years, we are indeed wondering when this period of "irrational exuberance" to paraphrase former Fed supremo Alan Greenspan will end. On a side note, for sports fanatics out there, baseball legend Babe Ruth personified the Golden Age of the roaring "Ballyhoo" twenties, a close second was the boxer Jack Dempsey. 

In this week's conversation, we would like to look at housing as yet another sign that we think we have reached "peak" US economic activity.

  • Macro and Credit -  The real state of Real Estate in the US and the consequences
  • Final chart - Beware of the velocity in tightening conditions

  • Macro and Credit -  The real state of Real Estate in the US and consequences
Back in April 2012 we indicated the following relationship with the housing bubble: 
"The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fueling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012"  - source Macronomics, April 2012
- source Macrobond
The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea. Dry bulk cargo represents the largest part of the $380 billion shipping industry. Container shipping traffic is driven by consumer spending as it is dominated by consumer products. Container volumes to the United States are dependent on the housing market. Furniture and appliances are some of the top freight categories imported in both the United States but, in Europe as well from Asia. 

Any changes in consumer spending trends are depending on the health of the housing market:
- source Macrobond

With the Fed on its hiking mission, house affordability is being impacted through rising mortgage rates. Housing is getting more expensive in conjunction with labor shortages and rising costs linked to some extent to tariffs such as those on imported steel.

Basically it seems that the housing market in the United States seems to be stalling as affordability is becoming an issue:
- source Macrobond

Making a quick detour to shipping, there are as well signs that global trade is indeed cooling off. 

Another indicator other than the BDY is the Harpex Shipping Index. It is considered a good indicator of global economic fleet shipping activity since it tracks changes in freight rates for container ships over broad categories. It is slightly different than the BDY. Harpex weights average daily charter rates across eight size classes of vessels to formulate its index. A vessel containing dry bulk generally transports a single load type. Containers ship, by comparison, usually transport a wider variety of finished goods, which makers therefore the Harpex Shipping index a more accurate indicator for measuring global trade:
- source Macrobond

We can clearly see a deceleration in global trade happening at the moment thanks to this index.

But, let's return to US Housing. 

The housing market has clearly been the weak spot in the “strong economy” narrative. The Fed’s hiking path is leading to rising 30 year fixed mortgage rate towards 4.90%, the highest level touched since April 2011:
- graph source Macrobond

Single-family homebuilding is the largest share of the US housing market and fell by 0.9%. Housing affordability is becoming a challenge. 

At the same time, US housing prices are now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012:
- graph source Macrobond

On the subject of housing being a cause for concern, we read with interest Bank of America Merrill Lynch's US Economic Weekly note from the 19th of October entitled "Will housing hurt?":
"Will housing hurt?
  • We have made a number of changes to our housing forecasts to reveal a weaker trajectory of sales, starts and home prices amid rising rates.
  • We think home price appreciation is set to slow but not fall negative absent a recession in the overall economy.
  • Housing is no longer a tailwind for the economy, but the headwinds are blowing very gently.
Home prices: from boom to bust
Home prices nationally, as measured by the S&P CoreLogic Case-Shiller index are running at 6.0% yoy as of the latest data in July. Assuming some modest slowing into the end of the year, we believe we are on track for home prices to end up 5.0% this year, as measured by 4Q/4Q change. As we look ahead into next year, we expect the slowing in home prices to persist, leaving home price appreciation (HPA) of 3% at the end of 2019 (Chart 1).

Thereafter we expect home price appreciation to hold at that 3.0% pace in 2020.
Back to econ 101, home prices should be a function of housing supply and demand. As we argued in Home sales: the peak has been reached, we think existing home sales peaked at the very end of last year and have since been moving sideways in a choppy fashion. This is a function of affordability which has been challenged from rising mortgage rates and elevated home prices. Inventory levels have remained extremely low, but since we look for some continued growth in single family housing starts but little change in home sales, we could start to see the supply of homes increase. The modest shift in the demand curve and out of the supply curve naturally implies slower  home price appreciation. As Chart 2 shows home price appreciation typically peaks along with the peak in home sales.

With mortgage rates heading higher, the challenges with affordability will continue. As a simple rule of thumb based on the NAR’s affordability index, we find that a 50bp increase in mortgage rates would need about a 5.5% offsetting drop in home prices in order to keep affordability unchanged. Of course, this does not account for the rise in income which provides an additional modest offset. Plugging in forecasts for mortgage rates based on our rates strategy call for the 10 year to end this year at 3.25% and 3Q 2019 at 3.35% – which implies close to 5.15% and 5.25%, respectively, for the 30-year fixed-rate mortgage – we would see affordability continue to slip lower (Chart 3). 
While affordability would still be above the historical average, it would still be more challenging than the past several years.
Another important aspect when thinking about the trajectory of home prices is an idea called “mean reversion”. Home prices are ultimately anchored to a fair value which is a function of income growth. Based on the OECD’s methodology, we compare nominal Case-Shiller home prices with disposable income per capita, indexed to 100 in 1Q 2000 (Chart 4) which shows the overvaluation during the housing bubble given the irrational exuberance in the market and easy credit conditions.

The housing bust left prices to tumble back below fair value. Based on our calculation, prices are once again overvalued on a national level, albeit not nearly as much as during the bubble period. Over time the overvaluation can be solved in two ways: 1) home prices grow at a rate below income for a period of time to close the gap; 2) home prices decline to correct the valuation difference. The pull to fair value can be quite strong.
Regional realities
We have been discussing the national outlook for the housing market but the dynamics will vary on a regional basis. Focusing on the top 20 metropolitan statistical areas (MSAs), we find that all 20 are still witnessing positive YOY home price appreciation, ranging from a low of 2.8% in Washington DC to a high of 13.7% in Las Vegas.
Generally speaking the West Coast has seen stronger home price appreciation relative to other regions. This reflects the fact that the West has enjoyed robust economic growth, supported by the thriving tech sector, which has led to greater income and wealth creation. This subsequently feeds into housing demand and a bid on prices (Chart 5).

At the same time, the West has also suffered from greater building constraints and a more severe housing shortage, owing to restrictive land-use regulations and zoning laws. This has contributed to home prices well outpacing income growth. Unsurprisingly, a regional analysis of price/income ratios finds the greatest levels of overvaluation in  Western MSAs (Chart 6).

Conversely, the Midwest cities were generally undervalued.
The higher prices rise in overvalued regions, the harder they may fall. So outright price declines could be seen as demand pulls back, though as discussed earlier we think this is less likely for aggregate national prices. Meanwhile, more affordable areas should continue to see price gains assuming healthy regional economic growth.
Sales and starts are a bit weaker
While existing home sales have peaked and will continue to hold around 5.5 million through next year, we see further upside for new home sales, albeit only modest. We forecast new home sales to edge up to 665K next year from our forecast of 640K this year, which is up from 612K last year. Why would new home sales increase while existing home sales move sideways? The recovery in new home sales was much slower since builders were hesitant to add supply to a challenged market, particularly in the early stages of the recovery.
We have revised down our forecast for starts this year and next. We expect 1.260 million starts this year and 1.30 million next year. The gain will be entirely in single family construction as multifamily has little upside.
- source Bank of America Merrill Lynch 
While we expect single family starts to edge higher – consistent with continued elevated levels of NAHB homebuilder sentiment and low levels of inventory – we think builders will be cautious in the face of rising mortgage rates." - source Bank of America Merrill Lynch
Unfortunately we do not share Bank of America Merrill Lynch's optimistic view. That would not make us "perma-bears" but we do not fall easily prey to "Ballyhoo" games namely sensational promotion.

No offense to Bank of America Merrill Lynch but, Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street

If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:
- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Many pundits are predicting a recession in the US economy in the next two years.

As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up and when during the summer the house of sticks of the macro tourist carry pigs blew up (Turkey, Argentina, etc.). We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount to track going forward as the credit noose tightens.

Furthermore, it’s isn’t only residential housing which is a concern, in recent years Commercial Real Estate prices have gone through the proverbial “roof”:
- graph source Macrobond 
We think that "housing is no longer a tailwind for the economy" and that "headwinds are blowing very gently" is in this case a "Ballyhoo".

If one looks at US Homebuilders index versus the S&P500 that cyclicals matter when it comes to assessing the rising probabilities of a US recession:
- graph source Macrobond

This is telling you that housing activity is leading overall economic activity, housing being a sensitive cyclical sector. We have reached "peak" everything when it comes to US economic activity. It might be very well all downhill from there. We are already seeing signs in Europe with the latest PMIs of global trade deceleration, and not only from shipping mentioned above.

Also, if one looks at the S&P500 versus US Regional banks, one could conclude that "misery loves company":
- graph source Macrobond

The Regional Banks index has fallen 16.58% from its high back in early June and has fallen 7.05% since the start of October. Bank OZK’s stock dropped nearly 24% on the 19th of October after Commercial Real Estate (CRE) write-offs. The Arkansas-based bank is one of the largest condo construction lenders in Miami, NYC and LA. You would be wise thinking about selling your condo in Miami according to Main Street's predictive history.

As indicated by Bank of America Merrill Lynch in their weekly Securitized Products Strategy weekly note from the 22nd of October, bank stocks and MBS basis have a strong relationship since 2015:
"How Q3 bank earnings inform us
Domestic bank demand is key to agency MBS valuations; one simple relationship we have ascribed to is the strong relationship between bank equity valuations and the current coupon mortgage basis. Even recently, lower bank stock valuations have coincided with the basis widening. The underlying logic tying these two together is the outlook for bank balance sheets, reflected in stock prices, suggesting a technical backdrop for bank demand for agency MBS.
Many individual moving parts, however, come into play on the various pieces of bank balance sheets. For example, theory suggests deposits are impacted by the Fed’s balance sheet runoff. Appetite for securities relies on tolerance for capital volatility related to AOCI (all other comprehensive income), which changes with rate views and duration appetite. Finally, loans funded vary based on credit risk appetite and industry competitiveness, such as non-bank participation and accessibility to the high grade, high yield markets. These moving parts change, dampening or expanding bank demand for securities. We leverage the 3Q18 earnings call transcripts of the largest banks to extract takeaways on driving factors influencing these trends.
Lower tolerance for incurring AOCI risks – Tax reform, lower tax rates specifically, has reduced bank tolerance for incurring AOCI risks. AOCI losses have led to a larger tax deductible historically than what the current lower tax regime offers. The outlook for higher rates this year, and the potential for even higher rates ahead, has dampened enthusiasm for banks to take duration risk.
Cash is king, a compelling alternative, only getting better– Cash yielding 2+% compared to a post-crisis era of offering nothing raises the bar for investing in securities and taking on duration risk. Projecting returns on cash, along the forward path, only further stands to enhance the appeal of this strategy. Indeed, this is how the Fed’s tightening of policy works its way through banking channels, essentially raising the risk-free rate!
Yes, higher base case NIMs, but a few IF’s echoed – The selloff in rates highlights better NIM opportunities presented today, as deposit rates undershoot model forecasts. However, it is far from being just this simple. Convexity concerns and volatility ahead pose risks, along various forward paths. The outlook for loan growth, hinging on whether the economy keeps expanding, dictates securities demand, be it for HQLA/LCR reasons or for NIM/earnings.
The big question is can the US economy continue to expand as such a pace when housing is already struggling and even if FICO scores get lowered to facilitate credit card use by a pressurized US consumer?

There are indeed some implications down the line as highlighted by Bryce Coward from Knowledge Leaders Capital in his blog post from the 19th of October entitled "More evidence of a slowing housing market, and its implications":
"The slowdown housing activity leads overall economic activity by eighteen months. Housing, being one the most cyclically sensitive sectors of the economy, often feels the impact of higher rates well before other areas. This alone implies a peaking of economic activity right about now, leading to persistently slower growth rates through Q1 2020. 

Not coincidentally, a peaking of economic activity about now is also consistent with the 1.2% fiscal stimulus boost we’re getting in 2018. Incremental stimulus for 2019 drops to .4%, with the potential of that entire stimulus being negated by dead weight losses from tariffs, but that is a topic for another day." - source Knowledge Leaders Capital
This ties up nicely we think with Main Street sanguine view of the housing market, namely that it's less and less the time to buy a house and more and more the case of selling a house as per the previous credit cycle call Main Street made. The credit cycle is no doubt turning regardless of the "Ballyhoo" put forward by some pundits.

Sure overall, the latest quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points towards gradual tightening of financial conditions overall, yet the recent move based on the sensitivities of major market variables points towards an accelerating trend as per our final chart.

  • Final chart - Beware of the velocity in tightening conditions
Our final chart comes from Morgan Stanley US Economics note from the 11th of October and indicates how using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions:
"An updated view on financial conditions indices shows a mixed picture, with the
Chicago Fed’s FCI actually easing further in the week ending October 5, while other alternative financial conditions metrics show a more considerable tightening in recent days.
The Chicago Fed updated its weekly FCI this morning. The latest update covers through last Friday, October 5, so it’s quite lagged. Somewhat surprisingly, the index eased 0.026 points – the largest one-week easing since the week ending August 10 and the 13th consecutive week of easing for the index.

The index now stands at a level of -0.76, a low since July 2015, driven by lower readings on the risk, credit, and leverage subcomponents. 49 underlying indicators tightened in the last week and 56 loosened – some of the biggest contributions to easier conditions were the Markit IG 5-yr senior CDS index, HY 5-year senior CDS index, and the 3-month TED spread.
An alternative metric that we look at for a more real-time look at financial conditions has shown a greater tightening in financial conditions so far this week. This metric tracks financial conditions based on the sensitivities of major market variables in the Fed’s FRB/US macro model, and we express it in a fed funds rate equivalent.

By this approach, financial conditions have tightened about 10bp from last Friday and about 50bp from the end of September. That compares with the experience from early February this year when financial conditions tightened about 80bp over a two week period." - source Morgan Stanley
Is this velocity seen in greater tightening of financial conditions a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions, or is it simply a case of "Ballyhoo" at play? We wonder...

"Civilization begins with order, grows with liberty and dies with chaos." - Will Durant, American historian

Stay tuned!

Sunday, 14 October 2018

Macro and Credit - Under the Volcano

"A democracy is a volcano which conceals the fiery materials of its own destruction. These will produce an eruption and carry desolation in their way." -  Fisher Ames, American statesman

Looking at the large wobbles experienced in financial markets this week, leaving many pundits wondering if we had attained "The Amstrong limit" and trying to figure out if it was the start of something much larger at play, when it came to selecting this week's title analogy, we decided to steer back towards literature this time around. "Under the Volcano" is a famous1947 novel by English writer Malcom Lowry. The novel tells the story of Geoffrey Firmin, an alcoholic British consul in the small Mexican town of Quauhnahuac, on the Day of the Dead, 2 November 1938. When it comes to QE and alcoholism, we reminded ourselves our September conversation "The Korsakoff syndrome" being an amnestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). But what is of interest to us in our chosen analogy, is that this great novel of the 20th century has 12 chapters and the following 11 chapters beside the first introductory chapter happen in a single day. In similar fashion one could posit that the credit clock has 12 hours. In his novel Lowry alludes to Goethe's Faust as well as references to Charles Baudelaire's les Fleurs du Mal. We also used similar reference to Baudelaire's Les Fleurs du Mal back in December 2011 in our conversation "The Generous Gambler" and in 2014 in our conversation "Sympathy for the Devil":
"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.
Throughout Malcom Lowry's novel the number 7 appears, in similar fashion, we are seeing many signs reminiscent in the current credit cycle of the year 2007 or even with 1987 (the DJIA topped in '87 at 2700) given today we have both dividends and buybacks paid out in excess of operating cash flow.  Both are being funded with debt accumulation exactly as it was the case in the year 2007. Also, one may argue that somewhat, European bond investors made a "Faustian bargain" with Mario Draghi aka our "generous gambler" but we ramble again. 

In this week's conversation, we would like to look at once again where we stand in the credit cycle and ask ourselves how long until we see it definitely running.

  • Macro and Credit -  What's under the "credit" volcano?
  • Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"

  • Macro and Credit -  What's under the "credit" volcano?
As we pointed out in our most recent conversation, the latest quarterly Fed Senior Loan Officers Opinion Survey (SLOOs) continues to indicate overall support for credit markets yet the market feels more and more complacent à la 2007 we think:
- graph source Macrobond

The most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line. The Fed quarterly SLOO survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. The SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Credit always leads equities in our book.

Credit investors look at the CDS roll. The most recent roll into the new contracts was in September, the new “on-the-run” benchmark series. The current steepness of CDS curves is a headwind for anyone “bearish” on credit and wanting to express it through CDS products. Too costly right now:
Graph source Edward Casey - Bloomberg

Yet, there is no doubt rising “dispersion” which in effect means that credit investors are becoming more discerning when it comes to their selection process of various issuers’ profile. This we think is another sign of a late credit cycle.

To illustrate further the deterioration in the credit cycle overall picture, one could look at European High Yield and in particular Consumers and Cyclicals as shown in the below chart by DataGrapple on the 9th of October:
“It was a mixed session with BTPs, stocks and rates sending contradicting signals throughout the day. In credit, there was a constant theme though, as investors sold risk on higher beta auto and autopart related names. The sector has been heavy for a couple of days, a phenomenon that was pinned down to the upcoming EU environment ministers meeting to discuss emission caps, which is widely expected to result in a push for a more ambitious set of rules. It culminated this morning in a proper battering of TTMTIN (Jaguar Land Rover Automotive Plc) which saw its 5-year risk premium marked 45bps wider at the open. This aggressive move followed the September sales numbers reported by the company. The year-on-year decline amounts to 12.3%, as strong sales for new models were offset by weakness in China where demand dropped 46.2% on the back of import duty changes and continued trade tensions. This came exactly a month after Ralf Speth, the CEO, warned that a hard Brexit would cost the company £1.2Bln a year and would wipe out its profits. The company also confirmed the two-week temporary closure of its Solihull factory, which employs almost a quarter of the group’s workforce in the UK. Some profit taking on short risk positions eventually emerged at the end of the session and limited the widening of TTMTN’s 5-year risk premium to 28bps at 485bps, but the negative trend of the past nine months which is obvious on the above grapple shows no sign of abating and is in fact gathering momentum since the roll.” – source DataGrapple
With rising dispersion, and global trade deceleration and the effects of the trade war narrative, we are already seeing cyclicals underperforming. 

In similar fashion to 2007, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage or CLOs with lack of covenants such as Cov-lite loans as per the below chart from Bank of America Merrill Lynch, indicative of aggressive issuance:
- graph source Bank of America Merrill Lynch

What is of interest to us, regardless of the "liquidity" issues many pundits have been talking to about in relation to mutual funds and the strong growth in passive management through ETFs in recent years has been the rapid growth of the private debt market in this very long credit cycle.

On this subject we read with interest Bank of America Merrill Lynch High Yield Strategy note from the 12th of October entitled "The Next Credit Cycle - Scenarios for HY, Loans, and Private Debt":
"Private debt, the fastest growing segment in US credit
By its very nature, the private debt market is more difficult to analyze as most deals never get included in any widely followed indexes or make it into otherwise publicly reported portfolios. Even estimating the size of this market is a challenge, and we had to go about it backwards, by starting with known overall corporate debt stack and removing otherwise known and attributable pieces. We think, the market is somewhere between $400-$700bn in size, and it was the fastest growing segment of US credit, including bonds, bank and non-bank loans, over the past five years.
This report outline our understanding of structure, major investor types, growth, sector composition, leverage and covenant trends, key risks and mitigating factors of the private debt space. We find this asset to feature many hallmarks of a classic new hot market, which often results in unsustainable growth trajectories leading to eventual corrections, required to stabilize the market at longer-term sustainable levels. This report is also part of our broader take on US lending landscape that we published in collaboration with our banks and asset managers equity research and economics teams.
Loan covenants are the defining feature of this cycle
The syndicated leveraged loans continued to attract investor interest since the GFC, as their investment thesis (significant yield pickup coupled with no interest-rate sensitivity) remains appealing to many. As a result, the leveraged loan market has grown by 19% in the last two years, 44% in the last five, and doubled in the last ten. Strong demand forces asset managers have to compete for new deal allocations on both pricing and structures. Coupons are getting squeezed, leverage pushed up, and covenants dropped. And while tight pricing and elevated leverage are expected side-effects at this stage of the cycle, the degree of covenant deterioration has reached new levels in recent years, well beyond the outdated “cov-lite” label.
The next credit cycle: modeling potential credit losses
We bring all our knowledge of the three segments of leveraged finance – HY, loans, and private debt – in one place by running side-by-side credit loss models for three distinct scenarios: consensus middle-of-the-road, mild recession and a full-scale recession. Our interest primarily focuses on the last one as it helps us better understand the downside scenario and help us make more informed risk management decisions.
Key takeaways
We estimate the next credit cycle, when it happens, could bring credit losses to the extent of 2x of expected annual yield income in high yield and leveraged loans, and 1.3x in private debt. Investors could also experience temporary mark-to-market losses of up to 5x of their annual income. To put this downside risk into perspective, it would take a 325bps increase in yield to wipe out 2 years of yield income in HY, given the 4yr duration of this asset class. In other words, a 150bps increase in Treasury yields coupled with a 150bps widening in spreads is less damaging than a cyclical turn. While we do not believe the next credit cycle turn is imminent, this evidence improves our confidence in the existing positioning recommendation to begin underweighting lowest quality segments of the market in favor of higher quality segments." - source Bank of America Merrill Lynch
As per the above executive summary from their very interesting report, we do agree that the next credit cycle downturn is not imminent, yet we see rising M&A activity and rising dispersion as additional indicators of how late the credit cycle is. The summer drift for Emerging Markets has created some additional dispersion this time between EM High Yield and US High Yield as per the below chart from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

Both rising oil prices and strong earnings have been very supportive of US High Yield so far.

But, returning to the subject of loose covenants aka Cov-lite loans we read with interest Bank of America Merrill Lynch's take:
"Loan covenants are an epitome of this cycle
The syndicated leveraged loans continued to attract investor interest in the last few years, as their investment thesis (significant yield pickup coupled with no interest-rate sensitivity) remains appealing to many. As a result, the leveraged loan market has grown by 19% in the last two years, 44% in the last five, and doubled in the last ten. Both syndicated loan and CLO issuance is hitting new records (Figure 8).

With strong demand for loans in recent years, asset managers have to compete for new deal allocations primarily on two scales: pricing and structures. Coupons are getting squeezed, leverage pushed up, and covenants dropped.
CLOs are in a particularly sensitive spot, where their ability to compete on pricing and leverage is limited as they have to make math work over the cost of funding and adhere to minimum rating constraints. As a result, some managers could be more inclined to compete by accepting looser investor protections for the same price and leverage.
A typical CLO ramp-up period includes a warehousing stage that could last for about six months. During this stage, new loans are being acquired as a collateral for the future CLO deal, and an equity investor in a warehouse facility carries the risk of market conditions moving against them during this ramp-up period. Therefore, equity investors are incentivized to close the ramp-up period as soon as possible.
This pressure is counterbalanced by established time windows on CLO warehousing facilities, which arguably allow managers some flexibility to bypass on deals they view as particularly unattractive. The choice of a CLO manager could depend on how quickly such manager is expected to complete this stage. There is a premium associated with well-established managers. In some cases, CLO manager and equity investor are the same entity.
Pressure to ramp up a portfolio for future CLO at the time of record CLO issuance volumes puts some managers in a position where they are forced to compete on the strength of investor protections for a given level of credit risk/coupon.
Retail funds also contribute to excess demand for loan product as they continue to see inflows. YTD 2018, loan funds are seeing a 10% inflow, compared to a 9% outflow from HY funds. Loan funds have higher tolerance towards lower quality (B2/B3) paper compared to CLOs.
While there are some natural limits on how aggressive they can be on pricing (via pricing floor on their liabilities), there are no immediate consequences to accepting looser covenants. During the period when default rates are low (like today), the impact from looser covenants through lower loan recoveries is negligible. This would likely change, once default rate increase in the next credit cycle.
Key risks in continued deterioration of investor protections
Strong competition in the new CLO/loan asset management space in the last few years led to deterioration in key investor protections, such as restricted payments, asset sales, EBITDA add-backs, and incremental debt capacity.
These covenants are critically important to recovery in case of default, as they are capable of directly affecting the pool of assets available to creditors in bankruptcy, and the extent of creditors’ ability to establish claim over it vs. unsecured and equity investors.
Loan recoveries, defined as post-default trading prices, averaged a relatively high 65% since 2007 as a function a large proportion of loans recover near-par in restructuring. Tight covenant packages helped them achieve stronger controls over asset pools in bankruptcy or other distressed resolution.
This may change in the next cycle as key covenants have been eroded in recent years. Assuming the proportion of near-par recoveries is cut in half, average first lien loan recovery rate could drop to low-50s%. For example, on a $1.1tn loan market size with 15% peak default rate and 15% undershoot in recovery (50% vs 65% historical) this is an equivalent of $25bn of capital being permanently wiped out purely as a function of poor covenants. The next credit cycle is likely to bring some very poor recovery prints in certain most aggressive capital structures. We discuss various scenarios for defaults/recoveries later in this report.
Covenants are particularly weak in the broadly syndicated loan market, where the competition for new deal allocations is high. The private/direct lending space has also seen some deterioration in investor protections, but to a lesser extent than what we have seen in the syndicated transactions.
Key mitigating factors
Not all loans lacking covenants carry the same risk of low recovery. “Cov-lite” is not a new term, as it was coined at the end of last credit cycle, in 2006-2007, when a growing number of new loans were coming in without a maintenance covenant. In such cases,  issuers were not required to adhere to leverage tests once the loan was issued. We have long found this particular covenant mundane, as the experience of multiple breached maintenance covenants has demonstrated that lenders generally reserved their right to declare technical default, and instead chose to provide waivers for a fee.
Post-Global Financial Crisis, the number of such “cov-lites” has grown to the vast majority of new leveraged loans by around 2013, so again, not a new development. In a sense, the “cov-lite” misnomer is an unfortunate label that muddies the waters of a real problem for the next credit cycle, which is epitomized by the new structures lacking other key covenants.
(Definitions of certain key covenants: Structural subordination: Protection against lien dilution or structural subordination for existing lenders. Restricted payments: Protection against cash leakage and value transfers that depletes value of associated collateral. Debt Incurrence: Protection against issuers leveraging up or paying other debt holders at the detriment of existing lenders. Investments: Protection against issuer taking on risky investments through carve-outs and builder baskets. Asset sales: Protection for lenders to enable them to benefit from asset sale proceeds and excess cash flows.) - Source Bank of America Merrill Lynch
As far as aggressive indicators are concerned we have yet to see an equivalent surge into LBOs we did in the previous credit cycle as a percentage of market size as per the below chart from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

Given the deterioration in credit quality overall, as we have stated in numerous of our previous conversations we expect lower recovery values during the next downturn.

On the subject of what is "Under the Volcano" credit wise and what could possibly happen in terms of credit losses during the next downturn, in their report Bank of America Merrill Lynch does an interesting analysis:
"The next credit cycle: sensitivity analysis
In this section, we take three major asset classes under our coverage: HY, syndicated loans and private debt, describe their current pricing in fundamentals, and run three scenarios for the future (Figure 10).

The first scenario is base-case, consensus, middle of the road: the current economic trajectory persists, the Fed delivers on its dot plot estimates, and credit losses stay relatively modest, even for the floating rate instruments.
The second scenario, is the stressed case, which resembles a full scale recessionary environment, with earnings dropping 30% and the Fed being forced to cut rates back to zero. This is a scenario we pay most attention to in an attempt to properly manage a risk budget in coming years. The third scenario (shown in greyed-out columns next to stressed, is designed to represent a modest recession with better outcomes. Think of an energy experience in 2014-2015, perhaps a touch heavier or lasting a few months longer.
Note that while we show HY and syndicated loan spaces in two separate columns, the reality of the situation is that these spaces are not mutually exclusive as some issuers are present in both markets. With this limitation in mind, we think of this attribution as being defined by issuers that are predominantly HY or predominantly loans. We believe that such representation, while imperfect, allows us to more properly model the capital structure behavior of these otherwise distinct asset classes.
 Scenario #1: +100bp move in LIBOR, “average” loss ratesThis section is the base-case for the next couple of years, implies the macro environment remains broadly supportive and the Fed achieves its longer-term dot plot forecast. We note the following dynamics in our analysis:
  • The impact on issuer fundamentals here is visible in changing coupons to the extent they are floating, and interest coverage ratios (ICRs) change in response to coupons.
  • ICRs get somewhat problematic in syndicated loans and private debt space, but they remain generally manageable and comfortably above 2x.
  • Leverage here is assumed to be unchanged, even though one could reasonably expect both earnings and debt to grow, somewhat out of sync with each other, over the next few years in a scenario where the Fed is able to deliver four more rate hikes. We did not aim to make this exercise about our judgment on those two imperfectly synchronized growth rates, and decided to leave leverage assumption unchanged in pursuit of simplicity and clarity of more consequential arguments that follow.
  • We think some moderate credit losses could come out of this scenario, but unlikely to mark a turn in credit cycle more broadly. Such incremental moderate credit losses are more likely to surface in the syndicated loan and private debt spaces, where capital structures are predominantly floating rate.
  • Importantly, we do not view this scenario as being directly linked to the next substantial pickup in credit losses. This is not how the cycle ends.
Scenario #2: a full-scale recession
The key component of our sensitivity analysis is designed to define a full-scale recessionary experience.
  • We assume earnings decline 30% (normal recessionary range 30-40%), Fed cuts rate down to zero and Libor bottoms out at 0.50%, leverage/ICR ratios respond accordingly as functions of unchanged debt levels, lower earnings and somewhat lower interest expenses, to the extent of their floating nature.
  • Given these changes in issuer fundamentals, leverage would be likely to increase to 6.7xin HY, 8.6x in syndicated loans, and 7.5x in private debt.

  • Under these prevailing leverage conditions, we argue the default rates could hit 10% in HY (normal recessionary range 8-12%), meaningfully higher level of 14% in loans, and 12% in private debt.
  • The HY bond market has an established track record of peak default rates over three independent credit cycles, with a normal recessionary peak level of 8-12%. We thus argue for a middle-of-the-road type of default experience here in the next credit cycle.
  • Such track record is materially less reliable in syndicated loans, where the 2001-2002 cycle arrived when the asset class was in its infancy, and the 2008-2009 was arguably softened by the extraordinary policy response  aimed specifically at banks and structured finance products, although not directly CLOs.
  • Our argument for a 14% default rate rests on our understanding of substantial growth rates that were witnessed here in recent years, coupled with the higher leverage measures relative to other related asset classes. Leverage in the syndicate loan market could hit 8.6x under a moderate assumption of a 30% drop in EBITDAs.
  • Private debt space has no meaningful track record in previous credit cycles as the asset class has grown to its present size only in the past few years, although its early origins are traceable to the previous decade. We thus rely our 12% default rate assumption here primarily on its leverage measures, which are assumed to be (but not always directly observable) around 5x-5.5x, in between HY and syndicated loans.

• We also assume recovery rates of 35% in HY, 60% in loans and private debt. Recovery rates here are defined as trading prices shortly after the event of default. This measure differs from ultimate recovery, which is the payout on the other side of a restructuring process.
  • Syndicate loan recoveries are penalized as a function of three factors: poor investor protections/covenants and poor tangible asset coverage in sectors most exposed to syndicated loans (technology, services, and retail). We do give the loan market a benefit for the fact that its structure is now materially less exposed to mark-to-market instruments, thus limiting the extent of fire sales that took place in 2008-2009.
  • A 60% recovery assumption in private debt, is a very rough estimate, given absence of verifiable historical track records and extremely low liquidity. Paradoxically, the latter could be viewed as a benefit, as absence of any practical ability to trade out of a position could arguably prevent many private loans from ever being “marked-to-market” in a restructuring process. We aim to approach this question more holistically however, essentially making an argument that if an independent expert were to make a bona-fide assessment of such loan’s true market value in a distressed situation, he/she must have applied an additional discount for illiquidity.
  • While we heard a wide range of opinions on this particular aspect of our scenario analysis from various experts in this subject matter we felt that at the end of the day, inability to trade cannot be reasonably argued to increase intrinsic value, even if it does make its determination less transparent.
• Permanent credit losses are defined as the peak default rate times expected duration of the cycle (we assume 2 years) times (1 minus recovery rate).
  • We also calculate temporary mark-to-market losses based on assumed low print in secondary market prices of 65c in HY, 70c loans, and 60c in private debt. Naturally the confidence in these assumptions must be taken in consideration with expected depth of liquidity.
  • We separate between permanent and temporary loss here in an effort to highlight the fact that the latter is not crystalized unless an investor sells at that low print, although everyone is taken for a ride to that level. The permanent loss is unavoidable if a portfolio is exposed to an instrument in question.
  • We estimate permanent losses to be roughly 2x the current annual income generated in HY and syndicated loans and 1.3x in private debt. Temporary losses are estimated at 4-5x the annual income level.
  • To put it another way, investors stand to wipe out 4-5 years of their income if a recessionary scenario described above were to materialize in this exact form, although a material portion of that is likely to be recaptured in a subsequent upswing. They are also likely to never recover 2 years of their current income, assuming a passive benchmark exposure to HY/loans and 1.3 years to private debt.
 Scenarios #3: a mild/short recession
  • Highlighted in grey next to each scenario, we are also showing less stressed scenarios, to give readers a better sense of the range of likely outcomes. We think of these more- and less-stressed scenarios as equally likely to materialize over the next few years, dependent on currently unknown circumstances of the next downturn.
  • We also give the private debt a greater benefit of the doubt that recoveries there could be materially better in such less stressed scenario, function of lower leverage and better covenant protections in that space.
  • The key takeaway here is that temporary losses could be limited to 3 years of income in HY/loans and 2 years in private debt. Permanent losses could claim 1.5yrs, 1yrs, and 0.6x yrs respectively.
  • In a more optimistic scenario, we assume somewhat lower credit losses in loans and private debt. Default rates are assumed at 10% in this less stressed scenario, while recoveries are at 70% in syndicated loans and 75% in private debt (credit given for patient institutional capital, and better structured deals vs syndicated loans)." - source Bank of America Merrill Lynch
We do expect on our side, to repeat ourselves, lower recoveries into the next downturn given "Under the Volcano", there is we think the "liquidity illusion" which is an important factor to take into account in such a scenario analysis and exercise. Anyone who has been through the credit market turmoil of 2007/2008 will tell you that liquidity is a coward and often "bids" are "by appointment only" in such instances.

This is of course a concern which is as well highlighted in Bank of America Merrill Lynch's long interesting report:
"Constrained liquidity as a factor in our analysis
Liquidity has generally been a constraining factor throughout the history of leveraged finance markets. HY bond and leveraged loans have rarely provided investors with particularly deep secondary trading markets – at least, if one’s point of reference is determined by experienced in large cap equities, higher-quality bonds, FX, or commodities.
In the past, there were episodes when lev fin liquidity was relatively good, as was the case in 2006-2007. Additionally, throughout history, there were selected large capital structures that often had deep two-sided markets. Rarely do experienced leveraged finance investors expect deep liquidity to last over considerable time or encompass a considerable number of issuers in this market.
The topic of liquidity in the leveraged finance space has emerged as an issue of particular concern to credit investors, particularly after the Global Financial Crisis. After all, dealers curtailed their market-making activities as a result of both new regulations (capital requirements and the Volcker Rule, the latter which we detail later this section), as well as changes to dealer risk appetite and policies. The days of multi-billion dollar inventories of HY bonds on bank balance sheets came to an end shortly after 2008.
In recent years, aggregate dealer inventories in HY rarely exceed $5bn. This $5bn stand against a $1.3tn market by size and against $6-8bn of average trading volume it generates in a given day.
These facts lead to concerns that while the liquidity situation appears sustainable in times of inflows into the asset class, it may be easily disrupted in times of market stress and significant investor withdrawals. Additionally, if liquidity can be described as limited in HY bonds, and perhaps even more constrained in broadly syndicated loans, it is may be nonexistent in smaller middle-market and private debt spaces, where the whole tranches are often held in only a handful of accounts.
We generally share these concerns and agree with the argument that the next credit cycle will present an important test to the stability of leveraged finance market’s trading infrastructure. The key point here is to remember that while the AUM (assets under management) in funds promising investors daily liquidity gas grown by hundreds of billions of dollars in recent years, the dealer balance sheets went the other way and compressed to a significant extent. With all these reservations in mind, we do not count ourselves among doomsayers that predict a severe dislocation in corporate credit as a result of liquidity constraints.

As we introduced this topic above, we started with a description of the secondary market that has been perennially illiquid with exceptions due to unusually lax risk management episodes or unusually well traded cap structures. Seasoned investors who have participated in this market over several credit cycles understand its liquidity constrains on the DNA level.
The fact that dealers have stepped back has been balanced with the fact of new trading venues, counterparties, and instruments emerging to fill the void.

There are several competing electronic trading platforms in credit space today that did not exist prior to the financial crisis. Hedge funds and other opportunistic investor types are counting themselves among active market makers and they have stepped in during the recent episodes of market volatility with firm bids. Portfolio instruments such as ETFs, total return swaps, and options now complement CDX (credit default swap) indexes in allowing investors to transfer risk more efficiently.
Will the bid-ask spreads widen meaningfully in the next stress episode? Of course they will. Will the market necessarily malfunction in that scenario? Not necessarily. Recent deep stress volatility events such as Dec 2015 (a small distressed fund failing), Jun 2016 (Brexit), Nov 2016 (Trump election), and Jan 2017 (VIX fund failures) have proven that the leveraged finance markets continued to operate. In fact one could argue that all these episodes rewarded those who had the discipline, the risk budget, and the market sense to step in and take advantage of those temporary dislocations. We count ourselves among those who believe in this argument." - source Bank of America Merrill Lynch
We are no perma bears or doomsayers per se but, for us, liquidity in credit markets is a concern, particularly given record issuance levels in recent years also in private credit markets. The GAM fund meltdown during the summer is illustrative of our concerns. 

Growth in issuance is a problem also highlighted by Morgan Stanley in their Corporate Credit Research note from the 5th of October entitled "The Nature of the BBBeast":
"BBB IG debt outstanding has grown significantly in this cycle, a story most IG credit investors know quite well. For example, at ~$2.5 trillion outstanding, BBB par has increased 227% since the beginning of 2009.

The majority of the increase in BBB debt stems from net issuance ($1.2 trillion), followed by downgraded debt ($745 billion). Notably, the growth in BBB debt outstanding is not being skewed by a single sector or a small part of the market. Yes, large issuers have grown significantly. For example, the top 25 non-financial BBB names have a total of $685 billion in index debt (up from $257 billion in 1Q09). But the number of BBB issuers has also increased by 60% since 2009, while all sectors have increased BBB debt, large and small companies alike. In other words, the increase has been broad-based across the market.
So what does this mean big picture? Credit cycles are always different from one to the next. But a consistent rule of thumb over time that we live by when looking for problems down the line: Follow the debt growth. Very simply, applying to the current cycle, we think BBBs will be one (of a few) stress points when the cycle does turn. Downgrade activity will likely be meaningful. And when thinking about other markets that could feel the effect, remember the BBB part of the IG index is now ~2.5x as large as the entire HY index.
The good news is that this is not a story for today, in that ratings downgrades tend to lag the market. In other words, the big wave of downgrades will likely not come until credit spreads are much wider than they are right now, which will take time to play out. But more importantly, valuations are pricing in very few fundamental risks, in our view, with the BBB/A spread basis still near cycle tights. Hence we remain up-in-quality." - source Morgan Stanley
As central banks are pulling back, “macro” driven markets are no doubt making a return and credit indices such as Itraxx Main Europe and CDX IG and High Yield in the US are useful tool to hedge rising “liquidity” risk coming from credit markets when next downturn will show up.

Finally, for our final chart, as we pointed out during in previous conversations, 2018 displayed larger and larger standard deviations move, typical as well of late cycle behavior in conjunction with rising dispersion. 

  • Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"

The latest bout of volatility wasn't that much of a surprise, it was a conjunction of several factors such as fast rising real rates, a more aggressive tone from the Fed in general and Powell in particular. Whereas the February event was the equivalent for the house of straw of the short-vol pigs of the eruption of Mount Vesuvius in 79 AD, vaporizing in an instant large players of the short-volatility complex, the latest event was mostly a tremor, geopolitical risks aside. We do not yet see credit spreads turning decisively, nonetheless the deteriorating trend for cyclicals in conjunction with trade deceleration outside the United States warrants close attention we think. Our final chart comes from Morgan Stanley's Cross-Asset Dispatches note from the 11th of October entitled " FAQ After a Large Decline":
"Large moves are still happening more often: 
This remains true; 2018 is still on pace for some of the highest frequency of 3-sigma moves post-crisis. Liquidity remains poor.
What happened?
We think that recent moves are about several factors colliding around the 3.20% level for 10-year Treasuries, rather than a simple case of 'higher rates are bad for risk'. Those factors? A break of a 5-year+ real yield range, compression of the US equity ERP above 3.25% and very stretched performance of value versus growth (see Cross-Asset Dispatches: Are Rising Rates a Problem? October 7, 2018).
How unusual was this move?
The overall move for S&P 500 wasn't that extreme versus what we saw over the last several years but yesterday was the worst day for the NASDAQ in almost seven years. More broadly, this was also one of the worst days for growth globally. The value outperformance was even more pronounced outside the US as European value posted the best one-day performance versus growth post-crisis.
Positioning – it is light, but in pain: 
2018 has been a hard year (see Easier Financial Conditions, Still a Tough Year, September 23, 2018). The last five days have only confirmed this, bringing losses to one of the last bastions of strong performance and concentrated positioning – growth/tech. Investors have been hit hard by recent price action, which makes us less optimistic than we'd otherwise be about overall positioning indicators looking quite light.
2018, unfortunately, seems to be a year where every asset class has a turn in the barrel.
The Fed 'put' remains out-of-the-money: 
We also do not expect much help for policymakers, at least not yet. US inflation and unemployment remain in a very different place than under Chairs Yellen and Bernanke. As of late September, the Chicago Fed's Adjusted Financial Conditions Index was still easier year on year (in a tightening cycle, we think that the Fed would want this tightening). And we think that the Federal Reserve strongly values its independence; comments by the administration are unlikely to have an impact." - source Morgan Stanley
Sure, things are brewing "under the volcano à la 2007", one might opine, and of course geopolitical events continues to be known unknowns, yet the US still appear for the time being as much stronger magnet for global capital than Europe for instances as per the significant amount of outflows seen in recent weeks. It is again a case of "Dissymmetry of lift" we think, yet, the latest signs of global liquidity withdrawal are showing again dispersion such as rotation from growth to value, and investors turning more defensive in some instances given we are entering the latest innings of this long credit cycle but, we are repeating ourselves again...

"Hope of ill gain is the beginning of loss." - Democritus
Stay tuned !
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