Canaries in the monetary coal mine?

Published on 20-12-2017 09:09:1020 December 2017

Steinhoff and HNA Group are from different regions and sectors. Yet they are making the headlines for the wrong reasons as the market raises questions over their debt sustainability. What these firms do have in common is that have pursued a policy of debt-financed acquisitions during this cycle. Now, LIBOR rates are pushing markedly higher. These signals of tightening credit bear watching in our view, even if they are presently not a cause for immediate alarm. It is however our important to be alert to early signs of a turn in credit availability. This is likely to first occur at the margin of the credit risk spectrum, as in 2007/8.

Kindleberger wrote in his classic Manias, Panics and Crashes that “The specific signal that precipitates the crisis may be a failure of a bank, or a firm stretched too tight, or the revelation of a swindle”. He was describing the event that ended a period of investor euphoria, which followed a period of easy credit and rising asset prices. Such specific signals are in general more easily identified in hindsight. We are intrigued therefore that certain firms are now experiencing credit issues in a market where high yield issuance is up 40% on a global basis year to date.

Exhibit 1: US 3m LIBOR rate increases accelerating into year-end

We would also highlight that even as many equity markets make new highs for the year, interest rates are rising. In recent weeks, US 3m LIBOR rates have accelerated their upward move as markets express greater confidence in the US Fed’s trajectory of 3 further rate increases in 2018, Exhibit 1.

In Europe, the market for offshore US dollar funding is also tightening, albeit modestly, as measured by cross-currency basis swaps. These swaps measure the haircut on LIBOR received when swapping euro funds for US dollars. It is not, thus far, a large change and it is also possible the effect is technical and related to US firms becoming more reluctant to lend dollars in the short-term due to changes in the US tax code. The ECB’s asset purchase policies may also have created an excess of euro-denominated funding which needs to be swapped into dollars. Nevertheless, this data should also be monitored as it proved a harbinger of the credit crisis of 2008.

It may be counter-intuitive but we continue to believe that even in this period of economic optimism and positive investor sentiment ,low risk premia suggest the market risk/reward is less favourable than usual. Fewer questions tend to be asked when the market is rising and future growth prospects are generously rewarded by investors. In raising these points, we feel we are going against the grain of current investor thinking. However, in our view the metaphorical wall of worry which followed the financial crises of the 2008-2012 period appears, finally, to have been fully climbed. As a result, the significant potential for excess capital appreciation from the depressed valuation levels of 2009-2012 has already been realised.

From here, the economy has to remain in the ‘Goldilocks’ zone – not too hot, not too cold – in order for equity markets to deliver just average returns, if current equity market valuations are a guide to the medium-term. Even if that remains for now the most likely scenario, it is still one in which caution should prevail. Some investors may be comforted by detailed scenario planning or portfolio stress tests in this environment. However, events such as those at Steinhoff show that it is not the known unknowns which give rise to the existence of market risk premia, but the unknown unknowns.

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