In its Q3 results, Merrill Lynch today reported a write-down of $7.9bn across CDOs and US sub-prime, significantly greater than the $4.5bn disclosed in its earnings pre-release. Net revenues fell by 94% on Q3 2006 – as the joke goes, you can only lose 100% of your revenues, although this wasn’t far off. Both S&P and Fitch cut Merrill Lynch’s rating from AA- to A+, with S&P’s analyst describing the results as ‘startling’. Merrill Lynch’s share price was at one point 10% down, before staging a slight recovery.
If you’re an equity investor, investment banks have been a bad bet over the past few months (with the exception of Goldman Sachs). The Dow Jones is close to record highs, and yet the share prices of Bear Stearns and Merrill Lynch are 30% below the highs hit earlier this year. JP Morgan and Morgan Stanley are 15% down.
From what we’ve seen in the fixed income markets over the past few months, we think that the banks’ problems are going to get worse before they get better. In the leveraged loan market, for example, investment banks have struggled to shift loans from the jumbo LBOs off their balance sheets following the repricing of credit risk over the past few months. They have now started to have some success, but they are doing this by selling the bonds at discounts just to shift them before the end of the year and the annual reporting season.
One saving grace for investment banks is that they offer a range of services that cover different markets through the economic cycle. If M&A activity grinds to a halt, they can afford to take the hit, fire most of their M&A team, and employ a new department in, say, distressed debt. This is a luxury that companies like Northern Rock (and to a lesser extent, Alliance & Leicester and Bradford & Bingley) don’t have. As Richard argued on this blog last month, Northern Rock is in serious trouble because its entire business model is no longer valid.
Oh, and yet more terrible US housing data just out – existing home sales were -8.0% in September, way below expectations of -4.5% and the worst month since records began in 1999.
Alan Greenspan made the headlines at the beginning of this year when he said that the risk of a US recession was 1 in 3, and has since said that recession risk had risen. Larry Summers (former US Treasury Secretary and Chief Economist at the World Bank) put the risk at 50/50 in September. The truly horrendous data coming from the US housing market makes us think that the risk of recession is probably greater than this.
What does this mean for high yield bonds? Well there’s a very close correlation between high yield bonds and economic growth – strong economic growth coincides with strong profits, low defaults and tight high yield bond spreads (ie high yield bonds become much lower yielding bonds). When the economy is in recession, more companies are going bust and high yield spreads tend to be wide (ie investors demand a big yield to be compensated for the significant risk that their bonds will blow up).
This chart shows that high yield spreads (left hand axis) are severely out of synch with US economic growth (right hand axis, inverted). There are three possible conclusions that can be drawn from the divergence of the lines. Number 1: this credit crisis will blow over and the US growth rate will jump back to 3%. Number 2: the correlation between growth and spreads has broken down ("it’s different this time"), or number 3: the high yield market is very expensive.
I favour number 3. US growth has been below trend for about a year, and yet high yield spreads actually reached their tightest ever levels in May this year. Spreads widened a bit over the summer, but are still close to all-time lows on an historical basis. And if you consider that US growth is likely to fall towards zero and possibly lower, then history suggests that the average high yield bond should yield around 12%, not 8%. A correction of this magnitude over the course of one year would result in double-digit negative returns. The European high yield market closely tracks the US market, and I remain very underweight of high yield assets across my portfolios.
Data from Moody’s shows that the global high yield default rate fell to just 1.27% in September, the lowest rate since March 1995. The global default rate has now been below 2% for 25 consecutive months, the longest stretch since 1978 (when the high yield market didn’t really exist).
The steady decline in the default rate has been a bit of a surprise – indeed, Moody’s model has been predicting a rise in the default rate for about the last two years. The likely reason for the model’s error is that companies that would have gone bust in previous cycles have escaped this time. In this liquidity-fuelled cycle, investors have been perfectly happy to bend over backwards for companies. Covenants have been broken, which legally allows bond holders to bring in the receivers and sell the company’s assets to recover their money, but investors have instead been happy to waive these breaches. In a worryingly large number of cases, troubled companies have been able to borrow even more money from investors to help them out of a hole.
Events of the past few months have resulted in liquidity drying up, and this almost unlimited supply of funding looks to be a thing of the past. Banks have had severe trouble getting financing lately, let alone rickety junk issuers, and the default rate should tick up as bond investors start to rein in lending.
Another indicator that defaults should pick up is that US interest rates have peaked. This chart (click to enlarge) shows that the global default rate has traditionally risen (and sometimes significantly) following the last Fed rate hike of a cycle. The observation makes sense – when the Fed believes it’s time to start slashing rates, the economy is usually a mess and monetary policy is too tight. Tight monetary policy means that there is little liquidity, it is expensive for companies to raise new finance, interest payments are high, all of which causes companies to run into difficulty.
You get a similar story when you mark the high point of the US rate cycle on a graph of high yield spreads, which isn’t a shock seeing as spreads and defaults are closely correlated. As this chart shows (click to enlarge), spreads normally start widening just before the final Fed hike in the cycle. This time around though, spreads initially tightened following the final rate hike in June 2006, and the long-awaited sell off only started in June this year. High yield spreads are still very tight on an historical basis, probably because the default rate is still so low. Spreads should widen in tandem with a rising default rate.
Confidence among US home builders has hit an all time low in October, breaking the previous record set in January 1991. All components of the survey were weak – present sales fell to an all time low (breaking the January 1991 record), future sales were unchanged (staying at an all time low), and prospective buyer traffic slipped below the previous record set in December 1990. The data suggests that the pain will continue until the huge overhang of properties begins to unwind. Bigger discounts and incentives have failed to revive demand, and further house price falls seem inevitable.
The report underlines Ben Bernanke’s comment earlier this week, when he said that the housing market’s contraction will be a "significant drag" on US growth into next year. The Fed "will continue to watch the situation closely and will act as needed to support efficient market functioning and to foster sustainable economic growth and price stability".
As I argued on this blog in August (before the Fed cut rates by 0.5%), the Fed will have to act fast if it is to prevent a slide towards recession.
The US Treasury Department announced yesterday that August saw a record net outflow of $69.3bn from US assets (equities, notes and bonds). This is particularly alarming considering that expectations had been for a $60bn inflow. The outflow was a combination of international investors selling US assets, and US investors buying international assets.
Perhaps most interesting of all was that Chinese investors decreased their holdings of US Treasuries by $8.8bn, while the Japanese reduced exposure to US assets by $24.8bn. Richard recently argued on this blog that a falling away of Asian support for US assets should cause the dollar to weaken.
Credit markets have enjoyed a fairly strong rally over the last few weeks, with spreads back to levels seen at the beginning of September. Some of the biggest gains have been in the areas that previously saw the largest losses, although asset backed securities (ABS) and mortgage backed securities (MBS) have still been among the biggest losers since the financial crisis began in June. One type of money market, the Asset Backed Commercial Paper market (which is used by many financial institutions for short term financing) has contracted from $1.3tn to $900 billion since the crisis began.
UK MBS backed by residential mortgages has suffered from the US crisis and Northern Rock debacle. Bonds that were rated AAA and yielded LIBOR + 10 basis point widened out to LIBOR + 50 basis points, although AAA spreads have tightened a little recently. Some BBB rated issues that were once yielding LIBOR + 50 basis points have widened out to levels usually associated with junk. Five year BBB paper now trades at around LIBOR +200.
Even at these levels, we are generally not buyers of residential MBS. As alluded to on this blog, our view is that this crisis has further to run. Credit rating agencies have downgraded lots of lower rated ABS/MBS deals, but are yet to make their move on a considerable number of so-called AAA rated bonds. When this does happen, we expect to see yet more repricing of this area of the structured credit market, and also anticipate some repricing in corporate spreads as former AAA deals crowd out A and BBB corporate land.
Taking a longer term view, it’s likely that residential MBS is going to be negatively impacted by a slowing of the housing market. Residential MBS will be hit hard if house prices fall, as delinquencies will inevitably rise. Slower repayment speeds on mortgage-backed deals will also slow the cycle of money being re-invested in new deals. ABS will not escape unscathed from a worsening consumer outlook either, as they are typically backed by things such as credit card repayments or car loans.
An area that looks a bit more appealing is the collateralised loan obligation (CLO) market – unlike CDOs, the underlying assets in CLOs consist entirely of leveraged loans, which are on the whole trading at attractive levels.
See this link for an excellent summary of the impact of recent financial developments on the US economic outlook from Janet Yelen, President of the Federal Reserve Bank of San Francisco.
“In determining the appropriate course for monetary policy, we must recognize that most of the data available now reflect conditions before the disruptions began and, therefore, tell us less about the appropriate stance of policy than they normally would. In addition to data lags, appropriate policy decisions must also, I believe, entail consideration of the role of policy lags–that is, the lag between a policy action and its impact on the economy. Addressing these policy complications requires not only careful and vigilant monitoring of financial market developments, but also the formation of judgments about how these developments will affect employment, output, and inflation. In other words, I believe it is critical to take a forward-looking approach—gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook.”
I was in Tokyo with Richard Woolnough-san last week. We think the perma-bears on the Japanese economy are wrong, and that some of the official economic statistics are masking an underlying recovery. There are some significant structural changes happening in the economy: for example, participation in the labour force by younger women is increasing dramatically, and immigration is increasing (albeit from an extremely low level). Both of these things could mitigate the problems of the ageing population that we are all familar with. The privatisation of the Japanese Post Office last Monday also has big implications – particularly for the Japanese Government Bond (JGB) market. Most Japanese people have savings accounts at the Post Office, paying, on average, a measley 18 bps per year. Japan Post typically invests these deposits in JGBs. But money has started to flow away from postal deposits (towards mutual funds – hoorah!) and this long term bid for JGBs could fade away. This is still very much a domestically owned market.
Elsewhere, whilst Japan has slipped back into deflation this year, we see this as a temporary trend. In particular there is a lot of criticism about the statistical methods used by the authorities. The price of housing and rents (a quarter of the CPI) is referenced on increasingly rare wooden homes, rather than the condo blocks where most people live. A regulated rebalancing of mobile phone bills away from handset subsidies towards lower monthly tarrifs will also have a massive deflationary impact in months to come, even though the net cost to consumers is likely to be a wash. And we learnt that the inflation stats haven’t coped well with the grocers reducing portion sizes (e.g. on pot noodle meals) whilst keeping prices unchanged (which should show up as inflation, but doesn’t). Positive inflation should be back in 2008 – another reason to underweight JGBs, although we think the nacent index-linked market looks to have value.
What could derail a Japanese recovery? Well 40% of Japanese GDP by value added is from the auto sector, and another 40% from electronics. Both of these sectors are big exporters, and a recession in the US would likely see Japanese growth slow back to below trend. The other risk is political – the radicals (economically liberal, global facing) appear to have been defeated and there is a risk of a return to "big government" and pork barrel politics (pointless state funded road building projects to appease regional interests). Further rises in the oil price would also be bad news for a nation which doesn’t have any of it – although it is somewhat protected by having 50% of domestic power generated from nuclear.
Finally, no trip to Japan would be complete without a gadget update. The next generation of TV screens are organic, and just 3 millimetres thin (and the picture quality is amazing); electronic purses have taken off dramatically for smaller purchases (Japan Rail runs one of the most popular schemes – you simply touch a pre-loaded card on a scanner to pay – no PINs or signatures); and Sony’s latest, er, thing, is called the Rolly, and it appeared to be a combination of dancing robot, lightshow and stereo speaker. Yours for 40,000 Yen (about £175).
When the Bank of England meets every month, market commentators always focus on the nominal interest rate. But what many people fail to realise is that it’s not the nominal interest rate that matters, it’s the real interest rate (ie nominal interest rates minus the inflation rate). If nominal interest rates rise from 5% to 6%, but inflation jumps from 2% to 4%, then real interest rates have actually fallen. Consumers will react by borrowing more, not less.
I was bearish on UK bonds through 2006 and the first half of 2007. Even though the Bank of England has steadily increased nominal interest rates from a low of 3.5% in 2003, real interest rates were at the same level in 2006 (about 2%). In reality, monetary policy at the beginning of this year was just as expansionary as in 2003, but four years ago the Bank of England was trying to avert recession and was worried about deflation. The Bank of England needed to raise rates this year, and it was little surprise that it has done so.
Since May this year, however, real interest rates have climbed rapidly higher. Even though the Bank of England has only raised nominal interest rates by 0.25% since May, the drop in inflation has meant that real interest rates have jumped by 1% (as shown by the yellow line on the graph). If you measure real interest rates using 3 month LIBOR, which is the rate at which banks lend to eachother and is therefore the rate that matters most to the man on the street, then real interest rates have jumped by 1.2% (as shown by the green line).
In reality, therefore, there has been a dramatic tightening of monetary policy over the past few months. High real interest rates will serve to reduce consumer borrowing, cut corporate investment, slow the housing market, and slow the economy. There is currently no need for the Bank of England to raise interest rates, and the next movement is likely to be downwards. The timing depends on how quickly and to what extent US woes afflict the UK, and how the UK housing market pans out (see my previous blog comment)
The dichotomy in asset markets has many, myself included, scratching their heads. Whilst the last four months have seen falls in the European and US high yield bond markets of approximately 1.3% and 2.9% respectively, equity markets have continued their upward trend. In fact, over the same time period the DAX has returned circa 0.8%, the S&P 0.9%, the DOW 3% and the MSCI Emerging Markets Index a whopping 20%. All are at, or near, their all time highs.
It would seem unlikely that both markets can ultimately be proven right. Whilst the equity market is no doubt aware that there are real pitfalls ahead, it appears supremely confident that central banks will be willing and able to reinflate their economies. I’m not so sure.
As an aside I spent a few days in the US last week trying to gauge the tone in the US bond market. The mood it must be said was somewhat mixed. Some argued that what we are seeing is more a mid cycle slowdown and were hesitant to talk too much about the dreaded ‘R’ word. Readers of this blog will be acutely aware of our bearish thoughts and I must admit the bulls failed to convince me otherwise.
Since Jim’s teleconference (see here) the asset backed and interbank markets have so far failed to normalise and US housing data has continued to come in below consensus (August pending home sales fell -6.5% yesterday). I fail to see how this withdrawal of liquidity and continued poor housing data won’t have wider implications for the US economy.
Finally the technical picture continues to look unappealing – several hundred billion dollars worth of pre-committed leveraged loans have yet to be sold, there is a risk of various structured vehicles having to unwind, and new issuers need to come to market.