A financial asset is nothing more nor less than a claim on future cash flows. So, when
asset prices motor ahead of incomes or profits, it means fundamental valuations
have deteriorated. Let the fundamentals erode long enough and far enough, and
financial instability is ensured. How could it be otherwise? Asset prices are the
sum total of stocks, bonds, and real-estate. When asset prices are high relative to
GDP, chances are good that you’ll encounter some combination of stretched P/Es,
outsized ratios of real estate prices to household incomes or rents, and bond yields
that are too low or credit spreads too narrow.
Since asset prices and incomes must, over sufficiently long periods of time, follow
an interlocked trajectory, an episode of asset price inflation will invariably sow the
seeds of its own destruction. In this cycle, the de-coupling of asset prices and GDP
has been extraordinary and is largely attributable to the central banks’ collective
flood of cheap credit. Rather than allow asset prices to find their natural, market
determined levels, the Fed, et. al. have harnessed extreme monetary “stimulus” in
the service of a bull market in risk assets. Artificially low rates have driven present
values to lofty levels fostering belief in the almighty central banker.
Wealth Economy Has Decoupled From Income Economy
Source: Bloomberg, TCW
But trees don’t grow to the sky. The Fed is, at long last, tip-toeing its way to a rate normalization. And a world made by low discount
rates can be unmade by higher discount rates. Meanwhile, capital that has piled into risk asset classes is growing increasingly wary
that underlying fundamentals do not validate the bull market in “everything.” The misnomer all along has been that while prosperity
naturally lifts asset prices, elevated asset prices alone do not create prosperity.
That said, the Fed is out of reasons/excuses to further delay raising rates: fiscal policy has dramatically upshifted, the labor market
is “beyond” full employment, growth is on steadier grounds, and deflation remains a no show.
What are the probable next chapters to be written? We can see two:
- The Fed lifts short rates and long maturity rates rise in tandem. In this event, discount rates rise out the curve leading to a
correction in asset prices. Rising 10-year Treasury rates would set up a “collision” between riskless yields on the one hand and
equity dividend yields and commercial real-estate cap rates on the other. History augurs against “immaculate” rate increases.
- The Fed lifts short rates but long rates stay “anchored,” causing the yield curve to flatten. In that event, term premia evaporate as
long rates and short rates converge. This is a distinctly bad outcome for virtually all financial intermediaries as the very basis of
banking, insurance, mortgage REITs, etc. lies in using short-term funding to finance long-term lending. As term premia skinny,
so do net interest margins (NIMs). At some point, rationally managed enterprises understand that shrunken NIMs requires
some form of de-risking, often in the form of a balance sheet de-leveraging. The result? Credit becomes both less available and
more expensive.
U.S. Treasury Yield Curve
Source: Bloomberg
2s-10s Treasury Spread
Source: Bloomberg
Barring some unforeseen zig back to a “Goldilocks” market, monetary policy has entered its late stage. Those years of cheap money
that sent enterprise multiples skyward have left a credit binge in its wake. Excesses in leverage are increasingly visible in wide
swathes of the economy, perhaps no more so than in the corporate sector:
Corporate Debt as % of GDP*
Source: Federal Reserve, TCW.
* Debt securities and loans of nonfinancial corporate businesses as a percentage of
U.S. nominal GDP, quarterly.
IG Credit Quality Has Steadily Deteriorated
Source: Barclays, TCW
A further confirmation of a late stage credit cycle is the enthusiastic embrace of financial engineering. Good investors do not believe
in alchemy and when deal sponsors resort to “off-color” tactics to justify their deals, it is an acknowledgement that traditional
metrics do not support the transaction. The tactics of financial engineering are many but we’d draw your attention to two of the
more prominent, i.e. covenant lite high yield debt issuance and EBITDA “add-backs.” Simply put, covenant lite issuance enables
the equity sponsor to dilute (or eviscerate) the contractual rights of the debt holder. Optionality that belonged to the bond holder
is signed away to management meaning that the assets of the business may never be available to protect the interests of the
bondholder, even if the company became financially distressed. In the case of EBITDA “add-backs,” management justifies a debt
issuance not by its “inadequate” GAAP earnings but rather by using a higher EBITDA equal to its GAAP earnings plus an “addback.”
While there can be situations where a pro-forma number may be “better” than a GAAP number, the proliferation in the use
of add-backs probably tells you all you need to know before you invest in today’s high yield market.
Underwriting Covenants: Uniformly Worse Than 2007
Source: Moody’s
As of September 30, 2017.
EBITDA Addbacks Are at Multi-Decade Highs
Source: S&P Global Market Intelligence
When the investment cycle is young or mid-stage, “risk-on” strategies swim with the tide. Portfolios with higher “ex-ante” yields
generate higher “ex-post” returns. Late in the cycle, this relationship reverses and rather than yield being the condition precedent
to gains, it becomes a leading indicator of principal impairments. The time to prepare for adverse outcomes is always before
the bear market. Those who do not heed the signs of danger will learn, first hand, why in investing, “Failing to prepare is preparing
to fail.”
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