“I am not afraid of storms for I am learning how to sail my ship.”
Many think Markets are set fair for the second half of 2023 – but what if a mighty depression is brewing out there in the ocean of corporate debt? I am looking at the glass (barometer for the non-nautical) falling and at the CLO market in particular. There may be a storm brewing.
As we enter the second half of the year, the consensus seems to be 2023 will be a good year – thus far. Apple is now a $3 trillion company. Tesla is selling more cars than ever. We’ve seen significant stock gains, there is clear upside from economies showing varying degrees of strength and resilience, global supply chain blockages are easing, and central banks have promised us inflation will moderate allowing them to ease rates. A soft landing in the US – but stagflation in UK. Move along, nothing to see here… everything is ok-ish…
Huh…. When you think the sun is shining is the moment to be worried. I am more and more concerned the rapid rise in interest rates and increasingly tight lending conditions means pay-back for the many years of easy credit is about to come due. Ultra-low interest rates have made us complacent about corporate credit. A storm might be coming.
But, let me start this fine July morning with a story about sailing….
I often find parallels between my fascination for markets and my passion for sailing. I think there is a lesson in this particular tale – markets are unpredictable and unstable. They can be roiled by unexpected no-see-ums without warning – just like sailing:
On Saturday it was the famous Round The Island race – a full day racing yachts round the Isle of Wight on England’s south coast – a 50 mile course. The weather forecasts were looking punchy, moderately strong westerlies, but nothing my crew couldn’t normally handle. We made a plan to sail safe – to reef early (reduce the size of the sails), and not to use a spinnaker over 20 knots.
We did pretty well for the first quarter of the race, despite stronger and more-gusty than expected winds. But when we got to the Needles – sharp pointy rocks at the Western end of the Island – we were hit by a 35-knot squall causing mayhem. Big seas broke over the rock bank below, while the wind roiled my lightweight boat. We were nearly hit by a much larger boat overtaking from behind – barely under control.
For the next 6 hours we struggled to hold a steady course in the shifty high winds, spun by the big rolling waves. It wasn’t particularly difficult, just frustrating as heavier boats were able to use their bulk to sail past us in straighter lines. Smaller boats seemed to handle the conditions better – hiding between the waves. Yet, it was carnage on the water – other boats broaching, and suffering mishaps with spinnakers wrapping round masts. While we sailed safe and slow the radio was constantly reporting man-overboards, dismastings and crew being injured. The local lifeboats were all out.
About ¾ of the race done is the most dangerous moment. The finish is in sight with one big turn from pointing North to steering West. This is where crews think they are nearly finished and get complacent.
That was where we spotted a boat upside down in the water off Bembridge at the north-east corner of the Island – a big, very expensive catamaran. I knew two very good friends were racing on her that day. I spoke to them later; they’re not entirely sure what happened, but a sudden gust as it turned into the wind overpowered the yacht, and it went right over before the crew could respond. One of them found herself tumbling into first the mainsail then the sea as the boat came over. Yet the only moment she was scared, she told me, was when the owners’ dog tried to clamber onto her head! Everyone was wearing life-jackets, including the dog. The crew were rescued in moments. She was a bit battered – and still made the point (losing the boat aside) it was a fantastic day otherwise. (Her iPhone lived up to its waterproof promise – been for a swim and it’s still working! Her husband’s Samsung – not so much…)
We then suffered an injury when we had to crash-gybe to avoid another boat (they weren’t looking out where they were going or were unaware we had rights). Part of the mechanism that controls our mainsail hit the trimmer’s shin, causing a Tarantino like explosion of blood – we retired thinking we need him rescued, but he kept smiling as we patched him up. Finally, one of our sail’s ripped as another gust caught us – at which point we really were finished. Every single member of the crew, including my limping wounded trimmer, exclaimed what a brilliant day they’d had.
For the record a couple of people were badly hurt, but no one died. Yes, the lifeboats and helicopters were busy – but I suspect they were equally enthused at the experience they gained. Yes, it was expensive. Yes, we made mistakes I will learn from…
Which brings us back to markets… how difficult will conditions be for the second half of 2023?
I reckon the market seas are set to become more choppy, and the economic headwinds less predictable than anyone expects. A storm of consequences this way comes. I suspect we are in for a more difficult ride than anyone expects. Much like my race over the weekend.
For a start I don’t reckon the global inflationary impetus is over yet. In the US we have ongoing strong employment, there remain significant supply chain problems (some can be solved overnight, but some take longer) while housing and wages are in recovery. Recession looks less likely – the risks may now lie towards an overheating economy! To hire new staff requires higher pay! The inflationary momentum in the economy remains strong. Although the headline rate may fall it could take much, much longer to slip back to the 2% the Fed keeps banging on about.. in which case higher for longer interest rates will remain in place.
Inflation feels like its embedded into the system – and that’s got all kinds of implications for markets that thought it would prove a short-term phenomena. What if it is here to stay?
Last week I said my main market fear for the remainder of this year is corporate bond defaults rising.
The consequences are already apparent – refinancing junk bond issuers (sub-investment grade is a $3.5 trillion market) are finding themselves being forced to pay double digit coupons, making their businesses unsustainable. As rates remain high, and defaults rise the inevitable consequence is tighter financing conditions – creating a negative “doomloop” in credit markets.
Thames Water will not be the only “private” utility in crisis – a decade of overly easy money means corporates got far too comfortable with cheap borrowing, investing not on new productive capacity or productivity gains, but on refinancing equity with debt through stock buy-backs. For the period between 2010-2022 lending conditions became easier and easier – including corporate loan covenants substantially loosened by investors and CLO managers to ensure the supply of new loans into their vehicles. Covenant-lite issuance could be the equivalent on not wearing life-jackets in a storm.
As the corporate doomloop deepens expect to see the effects playout in Collateralised Loan Obligation (“CLO”) markets – where their rising defaults could trigger a “judder” moment. Any CLO salesmen will tell you they are safe because they are diversified and attractive as they offer higher returns – just like Collateralised Mortgage Obligations (CMOs) did in 2007… Ho Hum…
In 2008 it was a sudden collapse in CMO prices caused by the realisation the housing market was grossly over-levered that triggered the Global Financial Crises and the near meltdown of the global financial system. There are over $1 trillion of outstanding CLOS – the managers finance around 70% of lending to already highly leveraged borrowers across the US and Europe.
In 2023 I have a nagging sense something wicked may happen in CLOs as defaults accelerate. If we see pain in the CLO market, it could trigger systemic crisis across bond markets, including high grade debt, right up to Treasuries and Gilts – especially if stick inflation means Central Banks keep conditions tight.
Its potentially a systemic problem for the whole debt market – investors from hedge funds to Sovereign Wealth Funds, Banks to Insurance, buy CLOs because they perceive them to be high-return and well diversified.. but a spate of junk defaults may trigger first losses on the equity and junior tranches of CLOs, leading to flight to quality. That could very quickly turn into a domino moment across the whole bond market ecosystem.
Shades of 2008? I’m thinking there is more to delve into here..
