Five lessons learned
admin | December 20, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Another year in the books, and another round of lessons learned. There were lessons about trade and rates, the Fed and systemic financial risk, the ability of big and complex markets to change. There were lessons about leveraged lending and about market cycles. Every year brings something new and valuable for the future.
The consensus around trade is shifting.
Trade and free flow of capital has shaped the US economy since World War II and US markets even more. The consensus did not reverse in 2019, but it did pause and move markets. The US this year used or considered tariffs against Argentina, Australia, Brazil, China, the European Union, France, Japan, Mexico and Turkey. And the US continued to move from multilateral toward bilateral trade relations. The model seems to be moving toward managed trade, where economics and politics seem more likely to mix.
Markets for Treasury and agency debt, agency MBS, corporate debt and CLOs, among others, all have an important audiences among foreign investors. Some, central banks especially, invest using foreign currency reserves generated through trade. Others invest because the US dollar is the global reserve currency. Others invest because the US is the broadest and most diverse debt market.
Consensus moves slowly, but trade has become a more important factor in US fixed income. Tariffs have clear effects on particular industries and issuers, more diffuse effects on economic growth, eventual effects on trade reserves. A bilateral world looks likely to create more risk and opportunity.
The Fed will respond to systemic financial stress.
The Fed showed again in 2019 that it will respond to signs of systemic financial stress, and that should bound risk in systemically important assets. The sharp tightening in financial conditions in late 2018 prompted a change in the Fed path in January. Trade tension and tightening conditions in May and June eventually prompted three Fed cuts. And unexpected stress in US repo markets has triggered an ongoing effort to flood money markets with liquidity. It seems that financial stability has earned at least a supporting role beside the stars of full employment and stable prices. That seems almost certain to condition pricing whenever either fundamental or technical factors destabilize markets. If markets start to anticipate a Fed response, they may eventually correct themselves on their own.
Big markets can be highly adaptive.
As Brian Landy points out elsewhere in this issue, the mid-2019 launch of the new Uniform Mortgage-Backed Security may go down as one of the smoothest sweeping changes ever made to the agency MBS or any market. After nearly four decades of convention where Fannie Mae and Freddie Mac securities traded separately and competed against one another, the UMBS initiative blended the two into a single TBA market. For a market with $4.6 trillion of outstanding MBS, thousands of originators using it to finance and hedge, tens of thousands of investors of all sizes worldwide, multiple systems for reporting prepayments, settling trades and tracking and analyzing investments, the transition went off with barely a hitch. The result reflected years of work by the GSEs, their regulator, investors, broker/dealers and data and systems providers. Next up: LIBOR.
Loan originators have stronger incentives for volume than quality.
Many of the banks and non-banks originating broadly syndicated leveraged loans today have stronger incentives to deliver volume than quality. The importance of private equity, demand from CLOs, and lower retention of loan risk by the originators all have likely contributed. Private equity now has a record $771 billion of unspent cash, making deal sponsors a potentially valuable bank customer across a range of businesses, and private equity sponsors have strong incentives to negotiate for flexible covenants and higher leverage. CLOs have become the dominant bid for loans, although no single CLO usually has enough exposure to a given loan to warrant aggressive negations against a private equity sponsor. Low retention of risk by the loan originators also limits incentives to negotiate for covenants and monitor credit. The rise of covenant-lite loans and other loose underwriting is well told. Compared to history, recoveries on these loans seem highly likely to be lower.
Evolution is a better model of markets than cycles.
Finally, investors, analysts and others almost every day wonder when the current long cycle of US growth and asset appreciation might end, but that very dynamic should put a big question mark beside the idea of a cycle itself. If markets really followed a predictable cycle, good investors would eventually arbitrage it away. That does not ignore real structural barriers to capital flow that stop attempts at arbitrage; there are plenty of those, but arguably fewer than in earlier decades. Monetary policy, most importantly, is not acting as if markets move in cycles. Fed policy is evolving in response to changing circumstances in the economy and markets. Markets consequently seem better described by evolution than by cycles. Investors are better off focusing less on diffuse cycles and more on the immediate impact of measurable factors on portfolio performance—rates, earnings, prepayments, policy and more. If B.B. King were an investor, he’d know the right tune: the arb is gone, baby, the arb is gone away.
Happy holidays, and all the best for 2020.
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