Monday 17 July 2017

The case for Senior Credit and Real Asset investing

  • We are late in the economic cycle in the US, China, UK, while Europe has large unaddressed internal imbalances
  • EM has gone through an adjustment 2011-2016 and the reforming countries have a positive outlook, while others deteriorate
  • The US/ UK credit super-cycle which started in the early 80s is coming to an end with Fed hikes, while the post WW2 institutional framework is increasingly irrelevant and the dysfunctionality is leading to reformist politicians taking power
  • The rebalancing/ reform period will likely be ushered in via a mild-US recession, and last 20-30 years
  • Main street will be favoured over wall street and wages will rise, squeezing corporate margins
  • Senior credit is protected from margin squeezes by the equity, while equity/ stressed debt opportunities prevail in post downturn areas as they start to recover
  • There are structural growth related opportunities in EM, excluding China which is yet to start its own rebalancing

Long term structural cycles
There are a number of long term structural cycle theories, whether Stauss-Howe generational cycle theory (4 generations per cycle of 85-100 years, with the current cycle having started in 1946 following the last crisis period of WW1 to WW2) or Kondratiev waves (e.g. 25 year booms followed by 25 year busts driven by economic change waves/ growth engines, the most recent one driven by the IT boom in 90's and noughties and China entering the global labour market in the early 90's).

Credit cycles
Similarly since we moved off the gold standard, effectively starting with the Treaty of Versailles in 1919, it has allowed credit super cycles. The first derived from the Treaty of Versailles which switched most of the gold supply to the US (German war reparations and UK/ French war debt payment) and created the roaring 20's in the US and then 30's bust, while Europe went through instability from 1918 to the outbreak of war in '39. The end of WW2 saw a new institutional framework based around Bretton Woods for the west's monetary regime, which again allowed a US credit cycle which busted with Nixon closing the gold window in '71, the ensuing period of inflation eroded 90% of the value of the USD and which ended with Volcker hiking interest rates into the mid-teens to kill inflation. That credit cycle reset between '71 and the early 80s then allowed Alan Greenspan to foster the current 35 year global credit super-cycle; a super-cycle that busted in 2008 and saw a policy response designed to reflate it.

The post-2008 reflation efforts, mainly by the US and China via fiscal and monetary stimulus, initially lifted all assets, but sequentially the most peripheral assets have crashed and the crashes are getting closer to the core. With, in my view, the UK potentially as the next downturn area.

The most supported areas/ assets in this cycle up to now have been: US large company earnings, US real estate, US high yield, Chinese SoE's, Chinese fixed asset investment sectors and Chinese real estate.

Fed policy and the beginning of political reforms
The Fed has a legal mandate on Core PCE to achieve a 2% target and to support full employment. The Fed doesnt use a financial/ asset market model in its modelling.

There are two important points to consider.

With U3 below the NAIRU estimates, the Fed is under pressure to 'normalize' interest rate policy. The current weakness in Core PCE is temporary and driven by weakness in Autos, some areas of retail and industrial sectors that have been affected by EM export weakness, a strong USD and the bust in oil/ shale. After that weakness passes, the rest of the components are in the 2-3% range and underpinned by upwards wage pressures.

As such the Fed could end the year feeling as though they are behind the curve and need 2-3% Fed funds in 2018.

The second point is the political changes we are seeing, which are associated with the fourth tuning of the Strauss-Howe generational theory. Under the Strauss-Howe theory new political leaders emerge to deal with the crisis that unfolds and part of this is reforming the economic structure and the institutional framework. Both Trump and Corbyn are clear fourth turning crisis leaders, while the EU has its own set of internal dynamics to deal with.

Key aspects of this rebalancing include pushing up wages as a percent of GDP, monetizing/ inflating debt away, corporate margins falling and defaults rising.

Essentially a new set of economic winners will emerge, primarily wage earners but also companies and assets that can do well from the new framework. This is not a short term change, but rather a structural cycle, the fourth turning is predicted to last 20-30 years. If the Fed sticks to a -2% real 'neutral' interest rate policy, it will take a long time for inflation to erode the real value of debt.

In my opinion we are still in the third turning, although Neil Howe believes the fourth turning started in 2008. Listening to Howe's comments he primarily defines the turning points as being culturally and politically triggered, which a few years later leads to the financial/ market transition. We are seeing political and cultural changes associated with the fourth turning now as the political narrative has changed in the last year.

The unravelling, third turning, is where the post WW2 institutional framework becomes increasingly dysfunctional and increasingly desperate measures are used to support it. If this started in 1997 with the Asian credit bust and then the post-2000 bust, basically the start of Albert Edward's Ice Age theory, then we are currently 20 years into a 20-30 year third turning cycle. As such the third turning could give way to the fourth turning at any time. I would guess the next US recession or a Chinese monetary crisis could be the trigger for the new phase from an economic standpoint.

So the Fed is hiking to meet its dual mandate and its policies will be appropriate for 'main street', but negative for asset markets, although it will err on the side of caution and Yellen has increasingly suggested that the new neutral interest rate was nominal GDP -2%. Similarly the political impulse is for pro-wage policies that will squeeze both corporate margins, push up discount rates for asset markets and shrink the FIRE economy as a percent of GDP.

The US has similar debt dynamics as the UK and both are seeing debt grow 3-3.5x faster than GDP. As the rebalancing takes place the demand that credit creation put into the economy will disappear, which is recessionary in the short term, and in the long term will squeeze the prior structural winners.

From an economic sectoral balance standpoint, the US consumer and government have been running deficits, while corporates and the external sector have run surpluses; these will reverse with corporates squeezed and the US becoming a net exporter over the period. Policies such as BAT taxes will support this sectoral restructuring.

Economic summary
So it seems clear to me that we are in a period of change and the changes will take time, be done under economic and market stresses and you need a completely different asset allocation framework to benefit from the new opportunities.

Liquid markets
Trading strategies should benefit from the instability. Buy and hold will be a disaster. EM macro has been working, but DM macro, CTAs, long vol and dispersion should work well over the next 5-10 years. Some forms of active risk premia should work well, but selectivity and timing will be key.

Post downturn areas are attractive. The equity is attractive if there is growth and self help/ auto stabilizers, e.g. oil, shipping. Stressed debt with a pull to par is better if the recovery is slow and margins remain depressed, e.g. most stressed/ distressed opportunities in Europe. Examples recently include Greece, Argentina where the post default complications lasted for years and debt was the better asset class vs equity. The next stress/ distress candidates are Puerto Rico, Venezuela, and perhaps the UK if we have a recession now.

There are structural growth opportunities in EM, but EM is a case of the good, the bad and the ugly; so selectivity is key. China clearly has big internal economic distributional problems and has a debt bubble to work off, so I would generally avoid it and its second derivatives such as Hong Kong and Macau.

Private markets
Private Equity
Equity earnings are going to be squeezed in the west, so most private equity is unattractive, as is commercial real estate as a second derivative that also has other structural challenges.

Generally, after the bust that is coming, there will be opportunities to buy cheap, cash producing, asset backed equity in companies that have pricing power and finance it with negative real interest rate debt.

In the west you have to wait for the crash, however there are current opportunities in post downturn areas: Energy, Mining, Shipping, Greece and some Emerging Markets. If the UK goes into a recession due to a housing downturn, austerity, real wage squeeze and no offset in investment, then it should present many opportunities.

I think the hurdle risk/ reward is a minimum of a 2x return with limited downside for unleveraged private equity. More involved, risky or leveraged situations call for more return.

Private credit
You want to avoid primary high yield or speculative bridge loans in overheated areas. London property developers are a good example; developers borrowing money at 15% to redecorate a vastly overvalued house only works in a bull market and will have high default rates as the market turns down. Generic mid-market senior lending where yields are fairly low and credit quality has deteriorated should be avoided. These areas are swamped with capital and many of the underlying businesses will struggle from here.

Instead you want to pick off niche areas on an intelligent basis. I think CLOs are attractive, I think there are senior lending opportunities in shipping, energy, mining, clean energy/ clean technology lease finance, some senior bank debt restructurings in Greece. There are some infrastructure related opportunities.

There are many senior opportunities in emerging markets, including India, Moscow, I'm sure if you looked in Brazil or other large EMs you would similarly find opportunities. I would avoid China and Hong Kong/ Macau. As an indicator, some residential real estate prices in Singapore have fallen 45% since 2011, given the commodity bust in Australia and Indonesia.

You can hold the senior secured credit on a yield of up to L+9% or so for very low risk debt. You could leverage this 2-3x if you want equity like returns with senior credit underlying. Or you can do a higher loan to value or some bridge situations and get teen yields, unleveraged, in post downturn areas.

If US nominal GDP growth now is circa 4.5% and that rises to 5-6% with some moderate wage-inflation pressure and the Fed has to hike to 3-4% over the next two years, yields should also rise in private credit in areas not swamped by investor capital. A 3 year loan book should get on average a 1/3rd principal and 10% interest receipt per year, so you can manage the portfolio over time. Fed rates of 3-4% vs 2% real GDP growth with a lot of the inflation being wages squeezing corporate margins is not going to be great for equity or the valuations of equity. (corporate profit falls in Q1)

There is nowhere else in credit you will be able to beat 5-6% nominal GDP with a comfortable margin and low default risks, even if there is a moderate yield reset in high yield, its still low quality credit at a time of rising defaults.

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