Inside Investment: Retread for the cycle
The smart money is already betting that the credit cycle is turning.
"With growing optimism, they gave birth to a foolish idea called the ‘New Economic Era’. That notion spread over the whole country. We were assured we were in a new period where the old laws of economics no longer applied."
This quote isn’t from someone looking back on the dotcom bubble. It is from the memoirs of Herbert Hoover, the 31st US president, who will be forever remembered for presiding over the 1929 crash and the Great Depression that followed. It serves as a timely reminder that clouds can appear in a blue sky and that economists are about as good a guide to the future as horse-racing tipsters.
Much of the current confidence in financial markets depends on the view that we are once more in a new era, one in which cycles no longer exist. The fall of communism and the opening up of India and China has been a 3 billion people-strong shot of adrenaline to the world economic system. These new producers and consumers, and the forces of globalization, have ensured the triumph of capital.
With labour in abeyance, the inflation genie that blighted the 1970s has been bottled up, perhaps forever. For true believers in the latest form of the new orthodoxy, the cycle is dead. But it is not just economists who are donning rose-tinted spectacles. Asset markets – from Chinese shares, to emerging market bonds, to commercial real estate – are built on a belief that easy money will forever flow.
US junk now trades at historically low spreads to risk-free government debt and so far this year has returned barely 1% more. The excess return of investment-grade credit over treasuries has all but disappeared. Junk trades like quality in debt markets; in equity markets cyclical stocks, such as the miners, are priced like the growth darlings of the TMT boom.
M&A topped $1 trillion globally in the first quarter, much of it driven by the hyperactive private equity sector. That in turn has fuelled $224 billion of new high-yield debt in the US alone. Cheap money and flush global liquidity conditions are allowing everyone to lever up – from the Buddhist monk scrambling to open one of 50,000 new brokerage accounts that starts trading daily in China, to the king of Wall Street taking private a company supposedly already fully priced by an efficient market.
They will hope that the good times continue to roll. However, there are signs that the cycle might yet bite back. One consequence of the US sub-prime debacle is that lending standards to Joe Public have already tightened. At the margin this will prompt consumers to save more and borrow less. There has been a historically unprecedented negative household savings rate in the US since the middle of 2003. If the sign changes to positive, even marginally so, the effect on aggregate demand in the economy will be significant.
But it is not just US households that are experiencing a turn in the credit cycle. Snippets from rating agency Standard & Poor’s suggest that the smart money is starting to think again about the cycle. Investors scaled back the high-yield loans that have been used to finance leveraged buyouts by 33% in February. Yields on loans to private equity firms and junk-rated companies have ticked up, from 7.47% to 7.76% in the past three months.
Appetite for so called covenant-lite loans (loans that offer almost no investor protection in the case of default) is also waning. Some $16.6 billion of such loans were sold in April, down from February’s record pace of $25 billion. This is not yet a credit crunch, or even a squeeze. The buyout boys can still finance their deals, just not on any terms. Quietly, almost imperceptibly, risk is beginning to be repriced.
The economists Hoover railed against included Irving Fisher, the most celebrated of his day. He opined with superb timing in September 1929: "We have witnessed perhaps the greatest expansion in history. The alarm over supposed inflation of security values seems unjustified by the recent record of dividend yield increases, which will doubtless be followed by much larger increases."
This is a classic example of linear extrapolation. It is the sort of analysis favoured by Chinese stock jockeys and LBO merchants and it invariably leads to penury. Fisher lost a substantial part of his own fortune in the crash and almost bankrupted the Yale University Endowment as well. Those betting on a New Economic Era now would do well to pay heed. We are not on the brink of a 1930s-style depression. However, the cycle is alive. It is well. And it is turning.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own