#QEforever

Credit is normalising, but… excellent commentary from Narrow Road Capital

If you haven’t done so already, we strongly encourage people to sign up to Narrow Road Capital’s insights on high yield and distressed credit markets. Even better it is free. Jonathan really puts together his thoughts in a very digestible format.

Jonathan has penned this excellent summary of the state of debt markets and cautions us not to get too excited. We have highlighted the things that stood out for us.

Credit is Normalising, But…

Credit securities, both in Australia and globally are getting back on their feet. The bookbuilds this week of $1 billion of corporate debt by Woolworths, $1.25 billion of RMBS by La Trobe and the $500 million of hybrids by Macquarie are all positive signs. However, secondary trading in many debt sectors is light and a few sectors remain moribund. Whilst the signs are generally encouraging, three dark clouds on the horizon point to the possibility of worsening conditions.

The leverage fuelled, panic driven sell-off started on February 24 and ran until March 23 . The circuit breaker was the Federal Reserve’s announcement of “unlimited quantitative easing”. At that time, there were widespread reports of global investors struggling to sell even the highest quality government bonds. Given how dire it was, it has been a relatively quick journey back from the abyss.

In Australia, major bank senior bonds recovered first and are now trading at similar spreads to three months ago. Corporate and securitisation debt has had a far slower recovery with trading remaining patchy. The large issuance this week by Woolworths and La Trobe, as well as a smaller issue by Liberty showed that buyers were willing to return. But unlike major bank bonds, spreads on corporate and securitisation debt have been reset at much higher levels.

At the same time as credit markets are improving, the economic outlook is also brightening in some ways with the gradual easing of restrictions on business. There is a growing view that the worst of Covid-19 has past and that a vaccine or drug treatment might not be far away. The optimism of the human spirit seems boundless with some investors seeing the pandemic as just another opportunity to buy the dip.

Where many investors are seeing mostly positives, I’m seeing mostly negatives. Australia has gone nearly 30 years without a recession leaving our economy fat and lazy. Asset prices (notably housing) have been propped up by population growth, credit growth and interest rates cuts, all factors unlikely to repeat. We’ve had over a decade of Federal Government deficits, destroying the legacy of Peter Costello’s decade of fiscal discipline. The economic buffers we had before the last crisis have been frittered away, leaving Australia poorly placed to withstand and rebound from the current economic and financial crisis. Given this backdrop, there are three standout risks for investors to factor in.

Remember 2007 – Fundamentals Matter

The bounce back in the last two months reminds me a great deal of 2007. In July 2007 credit markets slammed into a brick wall with credit default swaps and CDOs taking substantial damage. Bank bonds sold off as the riskier European banks started to have their solvency questioned. Yet after an initial shock, some of the markdowns turned around offering a window to get out with limited losses.

At first, equities and property continued on their merry way oblivious to the damage in credit markets. Australian equities peaked in October 2007 but held near record levels until January 2008. In December 2007, the property sector was slammed as Centro disclosed it couldn’t roll over its debt. Both at the time and in hindsight, the second half of 2007 was a bizarre period where fundamentals and market prices were so divergent. Given the medium term outlook for Australia includes significant unemployment and business failures, it is hard not to conclude that most investors are ignoring the fundamentals, just like they did in 2007.

Quantitative Easing

If the global debt markets are likened to plumbing, then quantitative easing is the duct tape used to cover the cracks. Central bank buying of government debt has delivered liquidity to debt markets at a time when governments and corporates are going on record borrowing sprees. If investors weren’t able to sell assets to governments via quantitative easing programs, they wouldn’t have capacity to buy the new issuance and bond yields would soar. Quantitative easing is beating back the bond vigilantes temporarily.

Australia has been a late entrant to this charade but is making up for lost time with the RBA hoovering up 7% of Australian government bonds in two months. At this rate, they will own the entire government bond market by the end of 2022. Whilst the RBA buying government bonds is the main game, there’s also been cheap funding for banks and the securitisation market. It’s no longer a case of merely providing liquidity against super safe assets, the recent purchases of sub-investment grade securitisation tranches come with the meaningful possibility of capital losses.

Whilst quantitative easing has yet to hit its unknown limits in developed economies, emerging markets have shown what happens when citizens and investors lose confidence in a fiat currency. The widespread use of US dollars in Argentina, Ecuador, Lebanon, Venezuela and Zimbabwe is the practical outworking of a country adopting funny money practices. At some point, the duct tape stops working and the value of the currency goes down the drain.

Global High Yield and Emerging Market Debt

Whilst most credit sectors are recovering well, corporate high yield debt and emerging market debt are on life support. The US high debt market has recovered around half of the losses that occurred since mid-February. However, this has been a quality driven rally with BB rated companies able to issue whilst B- and CCC rated companies are stuck in the doghouse. Several failed transactions have been a clear warning that lenders have little appetite for companies that can’t demonstrate their solvency in the medium term. The weaker airlines, energy companies and tourism associated businesses are looking at their cash positions and making calls about when to enter bankruptcy.

It’s a similar outlook for the weaker sovereign borrowers, particularly in emerging markets. The years leading up to this crisis saw an explosion in lending to the lowest rated sovereigns. Many of these countries are now turning to the IMF for bailouts; at last count roughly half of the world’s countries had put their hands up for help. There’s a global wave of jobs that will be lost as the weakest companies and countries are forced to reign in their spending. Whilst investors are pricing in a solid probability of defaults, they are ignoring the wider economic impacts of defaulting borrowers on the global economy.

Written by Jonathan Rochford for Narrow Road Capital on 16 May 2020. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.

The one fatal flaw experts forget when seeking to mimic #Abenomics style endurance

Pain

Over three decades ago, the Japanese introduced a TV programme titled, ‘Za Gaman‘ which stood for ‘endurance‘. It gathered a whole bunch of male university students who were challenged with barbaric events which tested their ability to endure pain because the producer thought these kids were too soft and self-entitled. Games included being chained to a truck and dragged along a gravel road with only one’s bare buttocks. Another was to be suspended upside down in an Egyptian desert where men with magnifying glasses trained the sun’s beam on their nipples while burning hot sand was tossed on them. The winner was the one who could last the longest.

Since the Japanese bubble collapsed in the early 1990s, a plethora of think tanks and central banks have run scenario analyses on how to avoid the pitfalls of a protracted period of deflation and low growth that plagued Japan’s lost decades. They think they could do far better. We disagree.

There is one absolutely fatal flaw with all arguments made by the West. The Japanese are conditioned in shared suffering. Of course, it comes with a large slice of reluctance but when presented with the alternatives the government knew ‘gaman’ would be accepted by the nation. It was right.

We like to think of Japan, not as capitalism with warts but socialism with beauty spots. Having lived there for twenty years we have to commend such commitment to social adhesion. It is a large part of the fabric of Japanese culture which is steeped in mutual respect. If the West had one lesson to learn from Japan it would be this. Unfortunately, greed, individualism and self-entitlement will be our Achilles’ heels.

It is worth noting that even Japan has its limits. At a grassroots level, we are witnessing the accelerated fraying of that social kimono. Here are 10 facts taken from our ‘Crime in Japan‘ series – ‘Geriatric Jailbirds‘, ‘Breakup of the Nuclear Family‘ and the ‘Fraud, Drugs, Murders, Yakuza and the Police‘ which point to that old adage that ‘all is not what it seems!

  1. Those aged over 65yo comprise 40% of all shoplifting in Japan and represent the highest cohort in Japanese prisons.
  2. 40% of the elderly in prison have committed the same crime 6x or more. They are breaking into prison to get adequate shelter, food and healthcare.
  3. Such has been the influx in elderly felons that the Ministry of Justice has expanded prison capacity 50% and directed more healthcare resources to cope with the surge in ageing inmates.
  4. To make way for more elderly inmates more yakuza gangsters have been released early.
  5. 25% of all weddings in Japan are shotgun.
  6. Child abuse cases in Japan have skyrocketed 25x in the last 20 years.
  7. Single-parent households comprise 25% of the total up from 15% in 1990.
  8. Domestic violence claims have quadrupled since 2005. The police have had to introduce a new category of DV that is for divorced couples living under the same roof (due to economic circumstances).
  9. The tenet of lifetime employment is breaking down leading to a trebling of labour disputes being recorded as bullying or harassment.
  10. In 2007, the government changed the law entitling wives to up to half of their husband’s pension leading to a surge in divorces.

These pressures were occurring well before the introduction of Abenomics – the three arrow strategy of PM Shinzo Abe – 1) aggressive monetary policy, 2) fiscal consolidation and 3) structural reform.

Since 2013, Abenomics seemed to be working. Economic growth picked up nicely and even inflation seemed like it might hit a sustainable trajectory. Luckily, Japan had the benefit of a debt-fueled global economy to tow it along. This is something the West and Japan will not have the luxury of when the coronavirus economic shutdown ends.

However, Japan’s ageing society is having an impact on the social contract, especially in the regional areas. We wrote a piece in February 2017, titled ‘Make Japan Great Again‘ where we analysed the mass exodus from the regions to the big cities in order to escape the rapidly deteriorating economic prospects in the countryside.

Almost 25 years ago, the Japanese government embarked on a program known as
‘shichosongappei’ (市町村合併)which loosely translates as mergers of cities and towns. The total number of towns halved in that period so local governments could consolidate services, schools and local hospitals. Not dissimilar to a business downsizing during a recession.

While the population growth of some Western economies might look promising versus Japan, we are kidding ourselves to think we can copy and paste what Nippon accomplished when we have relatively little social cohesion. What worked for them won’t necessarily apply with our more mercenary approach to economic systems, financial risk and social values.

Sure, we can embark on a path that racks up huge debts. We can buy up distressed debt and repackage it as investment grade but there is a terminal velocity with this approach.

The Bank of Japan is a canary in the coalmine. It has bought 58% of all ETFs outstanding which makes up 25% of the market. This is unsustainable. The BoJ is now a top 10 shareholder of over half of all listed stocks on the index. At what point will investors be able to adequately price risk when the BoJ sits like a lead balloon on the shareholder registry of Mitsui Bussan or Panasonic?

Will Boeing investors start to question their investment when the US Fed (we think it eventually gets approval to buy stocks) becomes the largest shareholder via the back door? Is the cradle of capitalism prepared to accept quasi state-owned enterprises? Are we to blindly sit back and just accept this fate despite this reduction in liquidity?

This is what 7 years of Abenomics has brought us. The BoJ already has in excess of 100% of GDP in assets on its balance sheet, up from c.20% when the first arrow was fired. We shouldn’t forget that there have been discussions to buy all ¥1,000 trillion of outstanding Japanese Government Bonds (JGBs) and convert them into zero-coupon perpetual bonds with a mild administration fee to legitimise the asset. Will global markets take nicely to erasing 2 years worth of GDP with a printing press?

Who will determine the value of those assets when the BoJ or any other central bank for that matter is both the buyer and seller. If the private sector was caught in this scale of market manipulation they’d be fined billions and the perpetrators would end up serving long jail sentences.

Can we honestly accept continual debt financing of our own budget deficit? Japan has a ¥100 trillion national budget. ¥60 trillion is funded by taxes. The remainder of ¥40 trillion (US$400 billion) is debt-financed every single year. Can we accept the RBA printing off whatever we need every year to close the deficit for decade upon decade?

In a nutshell, we can be assured that central banks and treasuries around the world will be dusting off the old reports of how to escape the malaise we are in. Our view is that they will fail.

What will start off as a promising execution of Modern Monetary Theory (MMT), rational economics will dictate that the gap between the haves and the have nots will grow even wider. Someone will miss out. Governments will act like novice plate spinners with all of the expected consequences.

In our opinion, the world will change in ways most are not prepared for. We think the power of populism has only started. National interests will be all that matters. Political correctness will cease. Identity politics will die. All the average punter will care about is whether they can feed their family. Nothing else will matter. Climate change will be a footnote in history as evidenced by the apparition that was Greta Thunberg who had to tell the world she caught COVID19 even though she was never tested.

Moving forward, our political class will no longer be able to duck and weave. Only those that are prepared to tell it like it is will survive going forward. The constituents won’t settle for anything else. Treat them as mugs and face the consequences, just like we saw with Boris Johnson’s landslide to push through Brexit.

The upcoming 2020 presidential election will shake America to its foundations. Do voters want to go back to the safety of a known quantity that didn’t deliver for decades under previous administrations and elect Biden or still chance Project Molotov Cocktail with Trump?

What we know for sure is that Trump would never have seen the light of day had decades of previous administrations competently managed the economy. COVID19 may ultimately work in Trump’s favour because his record, as we fact-checked at the time of SOTU, was making a considerable difference.

Whatever the result, prepare to gaman!