Macro and Credit - Zollverein

"An empire founded by war has to maintain itself by war." -  Montesquieu

Watching with interest the evolution of the Brexit negotiations in conjunction with the tone down stance between Italy and the European Commission surrounding the budget, while waiting for the next G20 and potential US and China ease in trade war tensions, when it came to selecting our title analogy, we reminded ourselves of the Zollverein, or German Customs Union. The Zollverein was a coalition of German states formed to managed tariffs and economic policies within their territories, organized under the Zollverein treaties in 1833 and formally starting on the first of January 1834. The foundation of the Zollverein was the first instance in history in which independent states had consummated a full economic union without the simultaneous creation of a political federation or union. The original customs union was not ended in 1866 with outbreak of the Austro-Prussian War, but a substantial reorganization emerged in 1867. The new Zollverein was stronger, in that no individual state had a veto. The Zollverein set the groundwork for the unification of Germany under Prussian guidance. After the defeat in 1918, the German Empire was replaced by the Weimar Republic and Luxembourg left the Zollverein. The rest, as we usually say, is history...

In this week's conversation, we would like to look at what the latest widening in credit spreads mean in terms of outlook for 2019.

Synopsis:

• Macro and Credit - So, you want to short credit?
• Final charts -  Change is in the air for global asset markets

• Macro and Credit - So, you want to short credit?

While we touched in our previous conversation on the widening of credit spreads in general and the impact of falling oil prices on high beta US High Yield CCCs in particular, there has been a lot of chatter recently around the lofty valuations in leveraged loans in conjunction with the fall in prices of the asset class.

Sure no doubt US High Yield CCCs is in the line of fire when it comes to its exposure to the Energy sector:

- source Bank of America Merrill Lynch

Oil prices and US High Yield are highly connected (15%). CCC bucket is feeling the pain right now with 20.1% of exposure to the Energy sector:

- graph source Bloomberg

For sure US High Yield being "high beta" no wonder they raced ahead of the pack when it was a good time to be long Oil. Given the recent unwind of the speculative long positioning in oil and clear deterioration in the global growth narrative, no wonder credit in general and high beta in particular is starting to feel the heat and there is more "heat" to come as per the below chart from Factset displaying the S&P 500 Energy Forward 12-months EPS vs Price of oil for the last 20 years:

- graph source Factset

As well, we argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. 

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will show it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg from our  November 2013 conversation "In the doldrums":

- graph source Bloomberg

There is a clear relationship we think between credit and macro from our perspective. Today the picture is more contrasted. 

While previously the data for Europe's aggregate PMI was more easily available, the below charts points to a faster deterioration in global growth in Europe (red line), while in the US given the credit cycle is more "advanced", Leveraged Loan prices have started in the US to fall faster than in Europe (blue line):

- graph source Bloomberg

Many financial pundits and central bankers are clearly worried, for good reason about the froth in the Leveraged Loan markets as we are seeing not only prices falling rapidly, but the growth of the sector has been significant as per the below chart from LCD, an offering of S&P Global Market Intelligence displaying the rapid growth in US Loan Funds Assets Under Management:

- graph source LCD, an offering of S&P Global Market Intelligence 

As we pointed out again in our last conversation, our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock".  As pointed out by the website "LeveragedLoan.com", outflows in both leveraged loans and high yield are starting to "bite":

"Investors Withdraw $2.2B from US High Yield Bond Funds, ETFs

U.S. high-yield funds reported an outflow of $2.19 billion for the week ended Nov. 21, according to weekly reporters to Lipper only. This result reverses positive readings in the prior two weeks, and brings the year-to-date total outflow to roughly $26.5 billion.

The year-to-date total exit continues to mark an unprecedented outflow from high-yield funds, outpacing last year’s total outflow of roughly $14.9 billion, which stands as the largest exit on an annual basis to date.

Mutual funds led the way, posting their largest outflow since February at $1.51 billion. ETFs saw another $682.4 million pulled by investors during the observation period. The four-week trailing average narrowed marginally to negative $427 million, from negative $470 million in the prior week.

The change due to market conditions was a decrease of $1.49 billion, according to Lipper. Total assets at the end of the observation period were roughly $193.4 billion. ETFs account for roughly 22% of the total, at $41.8 billion. — Jon Hemingway

US Leveraged Loan Funds See Hefty $1.7B Cash Outflow

U.S. loan funds reported an outflow of $1.74 billion for the week ended Nov. 21, according to Lipper weekly reporters only. This is the second major outflow of the past four weeks, and just the eighth negative reading of 2018.

Last week’s outflow was the heaviest since the week ended Dec. 16, 2015 ($2.04 billion) and comes just three weeks after a $1.51 billion exodus over the last week of October (this excludes a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 8, which came as the result of a reclassification at a single institutional investor).

With that, the four-week trailing average slumps to $767.8 million, its lowest level in nearly three years.

As with the other recent outflow, mutual funds led the way with $1.07 billion pulled out, while the total for ETFs was roughly $673 million. For ETFs that is the largest exit on record behind the $551.5 million loss for the week ended Oct. 31. Of note, ETF flows were positive in the weeks between, whereas mutual fund flows were negative for the fourth consecutive week.

While last week’s outflow puts a dent in the year-to-date total inflow, it remains a substantial $8.6 billion.

The change due to market conditions last week was a decrease of $774.3 million, the steepest decline since Dec. 16, 2015. Total assets were roughly $105.5 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $12.1 billion. — Jon Hemingway - source LeveragedLoan.com

The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost returned –0.52% in the month to date and 3.46% in the YTD. Sure some pundits would like to point out that contrary to the dismal performance of credit in 2018, in similar fashion to 2008 as indicated by Driehaus on their Twitter feed:

"YTD return is negative on each of the main US credit indexes (High Yield, Investment Grade and Aggregate). 1st time since 2008 that returns for all 3 indexes are negative through mid-November.  Lately, I find myself saying “first time since 2008” a lot more frequently" - graph source Bloomberg - Driehaus - Twitter feed.

Sure, the S&P/LSTA U.S. Leveraged Loan 100 Index is roughly around +3.5% YTD, so still overall unscathed some would argue.  Also in 2008, the index was down by a cool -28%, for perspective but we do think that if you want to go "short" credit, then indeed Leveraged Loans are a "prime" candidate" as pointed out by Peter Tchir in a July 2018 tweet:

"Many forget LCDX traded worse than HYCDX during 2008 due to positioning and then loans were more clearly senior." - source Peter Tchir, Twitter

Given the considerable size in Cov-Lite Loans in this credit cycle, then indeed, if the credit markets start unravelling, Leveraged Loans are clearly in the front line:

- graph source Bank of America Merrill Lynch

Of course Leveraged Loans, are starting to follow the painful path of other segments of the credit markets already in conjunction with global growth decelerating:

"Those of you glued to action in US equities to guide investment positions may want to devote some attention to this chart of returns to senior leveraged loans (SRLN) in excess of T-bills. Likely to be an epicenter of action in the next crisis, and currently breaking trend." - source Adam Butler - Twitter feed

Clearly if indeed credit markets start "breaking bad" in 2019, then for those of you not having the necessary ISDA to short the synthetic LCDX index could use ETFs to express their "short" view on Leveraged Loans as indicated by IHS Markit by Sam Pierson on the 26th of November in his article "ETF lending continues to thrive":

"Not all ETFs can be created out of borrowed securities, in particular those with exposure to illiquid asset classes. One such example is the Invesco Senior Loan ETF, BKLN, which consists of a basket of leveraged loans. The fund has seen increased demand from short sellers in Q4, with over $800m in current loan balances. Only a small handful of the underlying loans have any availability in securities lending, so borrowing shares from long holders of the ETF is essentially the only means of sourcing the borrow. Lenders have attempted to pass through increased rates, though the increased fees in late October and early November saw an immediate response of returned shares, driving fees lower. Once the borrow fee declined the balances picked up and fees have started to move up again. It's worth noting that BKLN has a 67bps expense ratio, which means that if short sellers can borrow for less than that rate there is an arbitrage assuming no movement in the underlying asset class. Additionally, the YTD increase in OBFR means that short selling any easy-to-borrow asset will result in a positive rebate to cash proceeds."

The $BKLN ETF is a popular way to hedge/short the asset class, in part owing the 67bps expense ratio (short sellers benefit from higher expense ratio, all else equal), though increased borrow costs over the last week may, again, dampen demand." - source Sam Pierson, Twitter feed.

As we have argued in our recent November conversation "Stalemate", Housing markets turn slowly then suddenly, same thing goes with Leveraged Loans as pointed out by Peter Tchir. 

The question that everyone is asking when it comes to credit markets as we move towards 2019 and the sell-side is sending out their outlooks is asking ourselves if we will be entering indeed a "bear" market in credit. On this subject we read with interest Morgan Stanley's synopsis and note from their 2019 Outlook for North America published on the 25th of November and entitled "The Bear Has Begun":

"We believe the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.

A more challenging macro backdrop: In 2018, weakening flows and tighter liquidity conditions served as the key headwinds in credit, but as an important offset, the US economy remained solid. In 2019, we think it gets tougher on both fronts – monetary policy will likely near restrictive territory for the first time this cycle, while the tailwind from a booming economy fades as growth decelerates and earnings growth potentially slows to a standstill. As that happens, late cycle risks may morph into end-of-cycle fears, continuing to break the weak links along the way, especially the more levered parts of corporate credit markets.

Late cycle and beyond: A turn in the credit cycle is not a specific point in time, but instead occurs in stages, over multiple years, beginning when growth is strong. With credit flows turning, financial conditions tightening, and idiosyncratic risks rising, we think that process has already started, slowly for now. And remember, the vulnerabilities in a cycle are always ignored on the way up. As this process continues to unfold and credit conditions tighten, the bull market excesses - this time centered around non-financial corporate balance sheets - should become increasingly clear.

A few silver linings: While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising fairly quickly, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. Additionally, while spreads are nowhere near where they will likely peak when the cycle fully turns, after the recent sell-off, valuations are not as extreme in places. Both of these factors help at the margin. That said, we very much stick to our bigger picture view that the credit bear market is under way, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality.

2019 forecasts: In our base case we forecast a -0.8% IG excess return, a 0.5% HY total return and a 1.3% loan total return. We expect $1.24tr, $183bn, and $436bn in IG, USD HY, and institutional loan gross issuance, respectively. Lastly, we project a 2.9% HY default rate.

Recommended positioning: In IG we prefer As over BBBs, Fins over non-Fins, the front-end of the curve, low $- priced bonds, US over European banks, and European over US BBBs. In HY and loans we remain up-in-quality, and prefer short-duration HY bonds. We have a modest preference for loans over HY, but think that view may change later in the year. In derivatives we prefer long CDX risk to cash, owning long-dated vol, positioning for decompression, and buying BBB CDS protection vs index." - source Morgan Stanley

As we pointed out in our previous note, credit mutual flows matter and it's probably matters as well for the Fed as well given the most recent dovish rhetoric coming from its chairman Jerome Powell. The latest price action in both the US dollar and Emerging Market equities is giving some much needed respite to the Macro tourists, which have been on the receiving end of the Fed's QT and hiking policy. 

Weakening flows clearly have been a trend this year in credit markets as indicated by Morgan Stanley in their long interesting outlook note:

"Restrictive Fed Policy and Decelerating Growth – a Tougher Combination

Tightening liquidity conditions should remain a headwind in 2019, at least initially, as the Fed pushes rates near restrictive territory, while continuing to shrink its balance sheet at the maximum rate, for now. Taking a step back, for most of 2018, we argued that a tightening in Fed policy, especially in the current cycle, was a material headwind for credit. In a nutshell, central bank stimulus was massive in this cycle, and highly supportive of credit. We thought the process in reverse, at the least, would weaken the flows into credit markets, driving higher volatility, with less of a “liquidity buffer” to cushion the shocks. In our view, these headwinds have materialized, just slowly and in stages. As we show in Exhibit 2 and Exhibit 3, flows into credit markets did weaken in 2018 across multiple sources.

Weakening flows clearly hit global credit markets this past year, one-by-one. For example, Exhibit 4 shows the spread widening in 2018 in US IG, in EM credit, in European credit, and most recently in US high yield, with financial conditions tightening in the process.

As we have frequently argued, fundamental issues are easier to hide when liquidity is flooding into markets, and it is not anymore. As liquidity conditions get squeezed, it is natural for dispersion in performance across asset classes, regions, sectors, and single names to pick up, with the weak links breaking first. US high yield was more resilient for most of the year than other markets, in part due to very low supply, and in part given its close ties to the strength in the US economy. But even HY, the "resilient" credit market, has only managed a roughly flat total return YTD, despite very strong earnings growth, a solid US economy, and supply down ~30%, which we think speaks to the importance of this tightening in liquidity conditions.

Looking to 2019 – two points are key to remember: 1) The liquidity withdrawal is going to accelerate, at first, and 2) unlike in 2018, it will happen as growth is decelerating. We think this will create an even more challenging backdrop, with the outperformance of higher beta credit fading as a result. On the first theme, as we alluded to above, our economists expect two more rate hikes in 2019 (after one more hike in December 2018).

We can debate where monetary policy sits in relation to neutral, but in our view, the flattening in the Treasury curve this past year, the tightening in financial conditions, as well as some of the weakness in key interest rate-sensitive parts of the economy, such as housing and autos, tells us that monetary policy is already pretty close to ‘tight.’ And remember, this tightening will not be just a US phenomenon going forward, as we see it. The ECB will be done buying bonds next year and hike in 4Q19, and the BoJ and BoE will hike in 2Q19, with the BoJ likely to reduce JGB purchase amounts as well, according to our economists.

But remember, throughout 2018, investors could consistently fall back on the idea that the US economy was booming with extremely strong earnings growth. Hence, it was easier to write off the multitude of macro headwinds (i.e, tighter Fed policy, tariffs, China/EM weakness, Italian politics, etc…) as “noise.” Going forward, these dynamics are changing. We expect US growth to decelerate notably, from 3.1% in 2018 to 1.7% in 2019, (with GDP growth of just 1.0% in 3Q19) as fiscal stimulus starts to fade, the interest rate-sensitive parts of the economy (i.e., autos/housing) continue to soften, financial conditions tighten, and tariffs weigh on business investment.

As we show in Exhibit 9, the global economy has already slowed, with the US bucking the trend so far, thanks in part to atypical late-cycle fiscal stimulus, but we think the US will converge to the downside as 2019 progresses.

Even more importantly, our equity strategists expect a material slowdown in earnings growth, with the likelihood of an outright earnings recession for a quarter or two in 2019 reasonably high. In their view, comps get very challenging next year, and margins will compress, with slower top-line growth and costs rising in many places, despite consensus expectations for margin expansion. We think markets are finally waking up to these earnings/growth risks with this recent sell-off.

Yes, 1.7% GDP growth is still manageable, and far from recessionary levels. In fact, one could make the case that this level of growth is ideal for credit – not too hot, not too cold. While we don’t disagree at a high level, we think details matter. In our view, slower growth in the middle of a cycle, which drives very accommodative central bank policy, is ideal. A slowdown in growth near the end of a cycle as a result of a restrictive Fed is not, and we think runs the risk that investors start to price in a higher likelihood that the cycle is coming to an end.

With growth slowing, and financial conditions tightening, will the Fed stop hiking? For now, we think the Fed "put" is fairly deep out of the money. Unlike at past points in this cycle, the Fed’s hands are more tied, with growth well above trend, unemployment at ~40 year lows, and core PCE now at 2%. That said, our economists expect the Fed to pause its rate hike cycle in 3Q19 and to end balance sheet normalization in Sep-19. For a short period of time, these dynamics could certainly boost sentiment. Longer term, we are not sure that they would be so bullish for markets. If the Fed stops hiking because they are at their perceived neutral rate and they believe inflation trends are benign, that may be positive. But if they stop hiking because the economy is weakening, that may be quite negative. In fact as we show in Exhibit 12, the biggest bouts of spread widening in a cycle, especially in HY, happen from the point when the Fed stops hiking, until deep into the rate cutting cycle, as that is when growth is rolling over.

Regardless of exactly when the Fed pauses, in this cycle, buying when growth is booming has not worked well (Exhibit 13), and we think this time will be no different as the macro backdrop reverts back down to, or even below, trend.

Adding everything up, we think macro challenges will grow in 2019. Monetary policy will continue tightening, with global central banks committed to removing stimulus, for now. All while the environment of very strong US growth and very robust earnings growth will fade. We think that backdrop will become even tougher for credit, especially some of 2018’s outperformers like US HY and loans, and continue to expose the fundamental challenges in the asset class built up over nearly a decade-long bull market." - source Morgan Stanley

Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end. Clearly the narrative has been changing and as we stated in our previous conversation:

"When the Credit facts change, I change my Credit mind. What do you do, Sir ..." - source Macronomics

Our final chart below indicates that change is in the air for global asset markets and that 2019 could prove to be even trickier than 2018 as the credit cycle continues to gradually turn.

• Final charts -  Change is in the air for global asset markets

The latest "dovish" take from Fed Jerome Powell's speech is clearly enticing to trigger some short term rally , we do think that 2019 will eventually be even more challenging as global growth is decelerating. Our final charts come from Bank of America Merrill Lynch from their Commodity Strategies 2019 outlook from the 18th of November and show that there is a trend for higher interest rates and volatility ahead of us:

"Equity markets are sowing winds of change

While higher real interest rates have been a clear headwind to gold, the rise in the global risk free rate also seems to push up equity market volatility. Our equity derivatives team has been warning about this trend of higher interest rates and higher volatility for some time (Chart 134).

True, global equity markets have been a tale of two cities this year, with US equity markets rising and the rest of the world lagging (Chart 135). But the pickup in volatility suggests that change is in the air for global asset markets

A rising VIX will eventually force the Fed to slow...

It is easy to forget that the S&P500 total return index posted a Sharpe ratio of 3.0 last year, but it is running just on 0.5 this year. Of course, the large pick up in equity market volatility (VIX) is hurting risk-adjusted equity market returns (Chart 136).

But also equity markets have struggled to break higher this year on a number of factors. The most important issue for gold here, however, is that a further drop in equity market values could eventually encourage the Fed to slow down its monetary tightening path (Exhibit 6).

So higher equity vol will likely lend support to the yellow metal going forward." - source Bank of America Merrill Lynch

When it comes to our Zollverein analogy, while Italy continues to be a concern, we believe that France should clearly be on everyone's radar as the situation is deteriorating in conjunction with its public finances. It remains to be seen if 2019 will see the New Zollverein aka the European Union coming under pressure as it did in 1919, leading in Germany to the introduction of the Weimar Republic but, we ramble again...

"Look back over the past, with its changing empires that rose and fell, and you can foresee the future, too." - Marcus Aurelius

Stay tuned ! 

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.

Synopsis:

• 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 !

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.

Synopsis:

• 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 9^th 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 !