The economic pattern we have seen since early 2012 is quite unique. Historically speaking, recessions involve a rather short preparatory phase where the slowdown is first noticeable. Then, there is a sharp drop in income, output and any other indication. Typically, that recession pattern was followed by an equally sharp rise in income, output and nearly every other indication; that is until the first appearance of the “jobless” recovery in 1991.
This was briefly discussed in late 2009 and early 2010 in the mainstream as economists were certain of the cyclicality of the Great Recession and thus recovery, particularly aided as it was by so much “stimulus” – it was expected to follow this typical “V” shape. It never materialized, giving rise to mockery (a “U” shape or even a “W”) but leaving behind another “jobless” period.
Even the slight forward momentum, which was actually evident across a broad section, arrested in that 2012 period. Almost every indication slowed in what appeared to be a preparatory recession phase. Yet, there has been no recessionary downslope (at least as far as the current benchmark estimates indicate – we will see if that changes once the NBER takes a closer look), instead leaving behind this “muddle.”
To my analysis, I still see the recessionary movements, but exaggerated and elongated by some other factor. Rather than the first, sharp move into the traditional “V” pattern, it looks much more like a smooth shoreline receding only gradually toward the ocean. This would be an unprecedented occurrence, but these stubbornly remain unprecedented times (as we careen toward five full years of ZIRP). It is a gentle downward pattern, but one that still leads you under water.
The most obvious candidate, and an exogenous factor at that, is monetary policy. We already know monetary policy is at work in the very evident bifurcation of the economic system. Take away automobiles, for example, and the goods economy looks downright nasty. So where credit is leaking through in narrower channels than in the past, it just may be responsible for keeping the economy from sinking faster.
To some, that is itself an argument for successful policy. To me it just prolongs the agony – successful policy would be, in contrast to that view, the “interest sensitive” sectors pulling the entire economy upward into that virtuous circle policymakers have been vainly expecting for five years now. Instead, we have this split economy, distorting distribution channels and networks that has little to zero positive “multiplier” in the larger real economy. That is not success, only delaying the inevitable whilst those most favored by asset inflation and credit (the least productive parts of the real economy) grow and expand to the longer term detriment of the system.
While the consumer has been largely absent from the credit orgy of the past two years, since mortgage and home equity channels remain largely unusable, businesses have loaded up (along with governments). This is particularly true among the lowest credit quality obligors, perhaps the ultimate beneficiary of this intentional repression forcing a “search for yield.”
There has been a growing amount of chatter and worry dispensed over leveraged loans and CLO’s that have worryingly found renewed life in 2012 and 2013. And there is no doubt it is something to be concerned over, at some point the credit cycle will turn and defaults will rise. But that is largely where the commentary ends, over concern for banks and financial health.
I think that is highly misplaced, and may have the cart before the horse. To me, the tremendous growth in junk debt and leveraged loans is of a macro concern now more than a financial concern. First and foremost, the flood of this “risky” debt has no doubt kept more companies in business than would have otherwise survived (or even allowed them to forestall cutting back, i.e., JC Penny) the downshift in 2012. That just may be the missing leading edge of the “V.”
That, however, raises a serious issue on the macro side. Back in March, the Federal Reserve, as part of its newfound sense of bubble proportions, changed the leveraged lending supervisory guidelines for federal bank regulatory agencies. It had not updated the guidelines since April 2001. To me, that was significant in that even the Federal Reserve, never shy about appealing to credit production, was at least alerted to potential imbalance.
The timing here, as I alluded to above, was in the midst of an epic boom in junk and leveraged lending. Junk bonds are probably familiar to most people, but leveraged loans are a class further down the risk curve. They involve companies already indebted to severe levels, so much so that banks will not directly lend, nor can these firms raise serious funds through even junk bond issuance. Instead, banks syndicate loans, portioning out among a group of banks, hedge funds and now mutual funds. That spreads the risk around, presumably making it more palatable to financial sensitivities (i.e., modeled risk).
When available, the leveraged loans are offsheeted into a CLO in much the same way as mortgage CDO’s were packaged in the last bubble. Again, my concern here is not about financial risk and contagion like that in the mortgage bust, particularly since CLO issuance is not nearly large enough on their own to bring down banks, but rather what the dizzying level of all this debt tells us about the saturation inside corporate financing. From that we can infer how large a role this debt is playing in just keeping the economy on a gentle downward slope rather than the expected “V.”
At the peak of the last credit cycle, leveraged loan volume was about $680 billion in 2007 (according to S&P Capital IQ LCD). There is a chicken and egg element here, but leveraged loan volume dropped precipitously to a little over $200 billion in 2008 and 2009. Depending on your point of view, companies either had little use for extra funds or the inability to obtain funds was a primary factor at the margins of the economic collapse. My sense of that period is much more the latter.
Issuance in 2012 actually surpassed the 2007 peak, hitting just above $800 billion, but projections for 2013 suggest that $1 trillion is in not only in sight but expected (even after the bond selloff). Again, focus has been on the financial risks, including the growing presence of “cov-lite” deals and dividend recaps. Both suggest that underwriting standards are, in defiance of the Fed’s updated supervisory guidance, falling back to 2007-levels of utter complacency. However, in light of the macro situation, we have to think about where that $1 trillion actually went (for what purpose) and what might companies do if they cannot so easily obtain similar levels of funding in the near future.
This is particularly true since more than half of that $1 trillion projection actually consists of “new money” rather than simple refinancings. Undoubtedly a healthy portion has been feeding the LBO/M&A boom, but the remaining is being used to finance basic corporate and production activities at weaker companies. Even where leveraged loans are being used in financial rejiggering (like LBO’s and dividend recaps) the companies that come out are burdened with debt, meaning their own business production and even survival is increasingly tied to debt markets and interest rates.
The bond selloff that ended on June 24 pulled some of these financing deals from the issuance docket. While there was $69 billion in “new money” volume in June, by August monthly volume was a distressingly low $17 billion. The Fed’s non-taper decision in September, “predicted” by dollar markets two weeks in advance, boosted leveraged volume back above $50 billion. But with taper unleashed as a hard concept, whether it happened in September or not, how would these leveraged-dependent businesses fare if the August total again becomes the “central tendency.”
Perhaps more than even junk bonds, the leveraged loan market is highly interest rate sensitive, particularly since the vast majority are floating rate at some spread above LIBOR. Expectations for any changes in short-term rates, taper et al, make a huge difference in a company’s decision to issue such debt. Under Bernanke’s assurances from September 2012, this seemed like a “no brainer”, allowing companies to issue greater quantities of debt without the interest cost (much like the Fed’s subsidizing the federal government). Disrupt that expectation, even a little, and the perceptions of the interest burden changes quickly.
On the other side, the rise of retail investors chasing yield is unprecedented. While we still may not know much about the impacts of funds on the stock market, we have little experience in credit markets, particularly here on the risk curve. In 2007, 8% of both total loan volume and new issuance was owned by prime funds. So far in 2013, 24% of total volume and an astounding 33% of new issuance has been taken by prime funds. Will retail investor appetite hold up under a rising rate scenario?
Rising interest rates are supposed to be the signal for “normalcy”, the epiphany of appreciation for monetary success. That might be true but only under the circumstances of the “V” pattern – on the upside of the recovery edge. Robust economic growth both diminishes the business risks to these weaker companies and means a greater ability to absorb any credit shock in this market. Absent robust growth, which even the Fed grudgingly admits, the story is entirely different. A credit crunch on even a gentle descent will change the trajectory.
Click here to sign up for our free weekly e-newsletter.
“Wealth preservation and accumulation through thoughtful investing.”
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@4kb.d43.myftpupload.com
Stay In Touch