Risk asset returns were generally positive in December across equities, credit and commodities. Equities in Australia (1.6%), the US (1.2%) and China (0.6%) led the way as Japan (0.2%) eked out a gain whilst Europe (-1.9%) fell back. Spreads contracted again on high yield debt as investment grade margins held steady. Copper (7.5%), iron ore (6.3%), US oil (5.4%) and gold (2.1%) made good gains whilst US natural gas (-3.0%) gave up ground.
As 2017 closes the near-term global economic outlook is roundly positive. Economic growth in the US, Europe and Asia is generally better than it has been since the financial crisis with growth forecasts mostly being upgraded. Global shipping volumes jumped in the second half of the year with the Baltic Dry index now at a 4 year high. Copper and aluminium prices have surged driven by increased demand and contained supply. The headline US unemployment rate has fallen to 4.1% after peaking at 10.0% in 2010 and unemployment claims are now at 40 year lows. Earnings for S&P 500 companies are forecast to grow at 11.8% in 2018 after growing at around 9.6% in 2017. There is much good news and investors desperately want the good times to continue for at least a few more years.
However, the longer term outlook appears to be built on shaky foundations. After 14 months in a row of global equities rising it seems as if there are no bears left. The evidence is mounting that investors are long risk across assets classes and regions. Some signs of hubris in debt include US consumers racking up credit card debt at a rapid rate, Asian high yield buyers skimping on due diligence and Europe high yield buyers rushing for subordinated securities as the lowest quality issuers ramp up debt sales.
Greek ten year bonds recently traded below a 4% yield even though almost nothing has been resolved in the country’s economy or debt obligations. A recent study from China found that 60% of Shanghai home loans included mortgage fraud with 30% involving borrowing to make the down payment. Many of the errors that caused the last credit crisis are being repeated, which raises the risk that the next one can’t be too far away.
Credit markets generally cope well with defaults as there has typically been a period of years leading up to the event where market participants can position themselves for the expected outcome. Investment grade buyers will have exited long ago. Some high yield buyers will also have left with the remaining holders ready and equipped to go through the workout process. The looming default of Steinhoff is one of the rare, ugly defaults that happens far faster than markets expected.
At the beginning of December, the company was sailing along smoothly with an investment grade credit rating. In less than a month the share price fell 90% and default is now considered likely after allegations of fraudulent financial accounts and the resignation of both the CEO and Chair. Lenders are cutting credit lines with talk of a January fire sale of the business units. Several notable losers are the ECB which recently bought Steinhoff bonds and four global banks that made a €1.6 billion margin loan to the former Chair. There’s debt of €10.7 billion at the head company and speculation that group debt could exceed €40 billion. It’s difficult not to see shades of Enron as what was a poorly understood but rapidly growing conglomerate faces its moment of truth.
Steinhoff was one example of the dangers of margin lending, several other risky variants are popping up. China’s HNA group is under a financial cloud and it used shares it owns in the Postal Savings Bank as collateral for a much needed loan. Investment banks are now offering leverage on complex and illiquid securities. A Japanese exchange is offering leverage of up to 15 times on Bitcoin, just one of a number of lenders accepting cryptocurrencies as security for loans. Margin lending works well when the collateral is liquid and low volatility, by messing with the basics these lenders are rolling the dice.
US Tax Reform
The reduction in the corporate tax rate in the US will increase the cash available for most businesses to service their debts, but there’s two groups that will suffer negative consequences. Fitch Ratings reviewed high yield debt issuers and found that limiting the interest deduction to 30% of EBITDA will see 10% of this cohort lose the ability to claim 50% or more of their interest. This increases to 40% of the cohort when the law changes to 30% of EBIT in 2022. Losing deductibility for interest isn’t a death knell for sub-investment grade lending, but over time it is likely to guide companies to reduce their debt loads to around B+ and above levels.
The second group facing a negative impact is those carrying over substantial losses in deferred tax assets. An example is Fannie Mae and Freddie Mac, who may need a capital injection from the US government after writing down the value of their carried over tax losses. For Fannie and Freddie, this might help nudge the US government to resolve their ownership and capitalisation status, which would be a good thing for all involved.
AQR Factor Claims
Factor investment (smart beta) house AQR released a paper this month claiming that fixed interest funds earn their outperformance over their indices primarily by taking additional credit exposure. For example, a manger could be comparing themselves to an investment grade index but using a 10-20% sub-investment grade bucket to generate additional returns. AQR goes on to argue that investors should ditch these funds and choose their factor based funds instead, which it says are generating true alpha.
AQR’s argument is substantially flawed in that their funds avoid taking on the factor that generates the most outperformance for credit, the illiquidity premium. This factor dominates the return contribution from the four traditional factors of value, momentum, carry and defensive. This is an inconvenient truth for AQR, as their business model relies upon putting their very large funds under management to work in highly liquid securities. It doesn’t mean they can’t add value compared to a traditional investment grade bond fund, but they will be soundly beaten by nimble managers like Narrow Road Capital that do take advantage of the illiquidity premium.
Basel III Bank Capital Levels
The long awaited Basel III amendments have been released after the American and European regulators found a middle ground. The two biggest changes are (i) limiting the maximum capital discount from internal models and (ii) applying risk weights to sovereign debt. The maximum discount on internal models relative to standard risk weights starts at 50% in 2022 and falls to 27.5% by 2027, significantly cutting the advantage gained by using internal models.
Sovereign debt rated A+ or lower will now require varying levels of capital backing, reducing the incentive to engage in the carry trade from holding weaker sovereign debt, which currently has no risk weighting. There’s also a sliding scale for residential home loans with more capital required as the LVR increases. These are all common sense improvements and when fully implemented will reduce the risk that taxpayer funds are called upon to bail out banks.
The proportion of banks that require additional capital is small, and there is a ten year phase in period. The losers are primarily European banks like Deutsche Bank and home loan banks that have a small amount of capital relative to their overall asset base. The ten year phase in period looks like a capitulation from the tougher regulators that have already forced their banks to build reserves. We are now over ten years on from the beginning of the last credit crisis. It is highly likely we’ll face another credit crisis well before the unnecessarily long phase in period is completed.
Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.