CANARY IN THE CREDIT MARKET´S COL MINE / CREDIT BUBBLE BULLETIN

Canary in the Credit Market's Coal Mine

Doug Nolan


What ever happened to "Six Sigma"? GE was one of the most beloved and hyped S&P500 stocks during the late-nineties Bubble Era. With "visionary" Jack Welch at the helm, GE was being transformed into a New Age industrial powerhouse - epitomizing the greater revolution of the U.S. economy into a technology and services juggernaut.

GE evolved into a major financial services conglomerate, riding the multi-decade wave of easy high-powered contemporary finance and central bank backstops. GE Capital assets came to surpass $630 billion, providing the majority of GE earnings. Wall Street was ecstatic - and loath to question anything. GE certainly had few rivals when it came to robust and reliable earnings growth. Street analysts could easily model quarterly EPS (earnings per share) growth, and GE would predictably beat estimates - like clockwork. Bull markets create genius.

It's only fitting. With a multi-decade Credit Bubble having passed a momentous inflection point, there is now mounting concern for GE's future. Welch's successor, Jeffrey Immelt, announced in 2015 that GE would largely divest GE Capital assets. These kinds of things rarely work well in reverse. Easy "money" spurs rapid expansions (and regrettable acquisitions), while liquidation phases invariably unfold in much less hospitable backdrops. Immelt's reputation lies in tatters, and GE today struggles to generate positive earnings and cash-flow.

When markets are booming and cheap Credit remains readily available, Wall Street is content to overlook operating cash flow and balance sheet/capital structure issues. Heck, a ton of money is made lending to, brokering loans for and providing investment banking services to big borrowers. That has been the case for the better part of the past decade (or three). No longer, it appears, as rather suddenly balance sheets and debt matter.

After ending 1994 with Total Liabilities (TL) of $158 billion (total equity $28bn), GE TL closed the nineties at $357 billion. Over the subsequent five boom years, TL increased to $382 billion, $425 billion, $507 billion, $563 billion and then 2004's $627 billion. TL peaked in Q2 2008 at $720 billion (total equity $127bn). A slimmed down GE ended Q3 2018 with TL of $263 billion supported by $48 billion of Total Equity. GE finished the quarter with Short-Term Debt of $15.2 billion and Long-Term Debt of $100 billion.

GE CDS (Credit default swap) prices surged 24 bps Friday and 86 bps for the week, to 259 bps. This was after beginning 2018 at 41 bps. It's worth noting that GE CDS closed this week at the highest level since the Fed "exit strategy" mini-panic back in 2011. But rather than commencing an exit from its bloated crisis-era balance sheet, the Fed proceeded over the next three years to double holdings again, to $4.5 TN. This extended GE's lease on life, along with the fortunes of scores of aggressive borrowers. Perhaps a $9.0 TN Fed balance sheet could save GE.

Most of GE's long-term debt is rated BBB+, "investment grade" but only a couple notches from high-yield (BB+). The worry is that downgrades will push GE debt to junk, forcing liquidation by funds and holders restricted to investment-grade holdings. "Moneyness of Risk Assets" has been a key analytical construct throughout this reflationary cycle (an evolution of "Moneyness of Credit" from the mortgage finance Bubble period). Fed (and global central bank) rate, QE, and market backstop policies incentivized (coerced) savers into the risk markets, especially in perceived lower-risk equities and fixed-income. With market yield way below investment return bogeys, many (pensions managers) were compelled to boost returns with leverage. Literally Trillions flowed into perceived safe and liquid "money-like" ETF shares. This flood of "money" into (higher yielding vs. CDs and Treasuries) investment-grade ETF products ensured the easiest Credit Availability imaginable for companies to borrower for capital investment or, more often, stock buybacks and M&A.

November 16 - Bloomberg (Brian Smith and Jeremy Hill): "Investment-grade bond spreads surged to the widest level in two years as a rash of concerns about corporate debt dented investor confidence. The spread on the Bloomberg Barclays U.S. IG Corporate Bond Index widened to 128 bps over Treasuries at the close Thursday, the widest since December 2016. The 6 bps jump was the most since the Brexit vote two years ago. Bond 'buyers have been relatively indifferent to corporations, and they focused more on rating,' said David Sherman, president of Cohanzick Management LLC. 'And now they're starting to bifurcate the 'haves' and the 'have-nots.''"

November 15 - Reuters (Trevor Hunnicutt): "U.S. fund investors are maintaining a wary position when it comes to bonds, pulling more cash after record withdrawals in October, Lipper data showed… Taxable bond mutual funds and exchange-traded funds (ETFs) based in the United States posted $1.2 billion in withdrawals during the week ended Nov. 14, Lipper said. Investors pulled $131 million from municipal bond funds in the eighth straight week of withdrawals for those products. In October, more than $53 billion tumbled out of U.S.-based taxable bond funds, the largest withdrawals on records dating to 1992, according to Lipper."

Losses are mounting, and liquidity is waning. U.S. corporate Credit is losing its "moneyness," with profound financial and economic ramifications. The June 2007 subprime eruption marked the inflection point for the "moneyness" of mortgage Credit. The "marginal" borrower/buyer lost access to cheap Credit, commencing a spectacular cycle's downside. Yet it was when the marketplace questioned the safety and liquidity of previously perceived "moneylike" "AAA" mortgage securities (and the money market borrowings of those heavily leveraged in "AAA"!) that full-fledged crisis took hold.

I remember the argument all too well. "Subprime doesn't matter." Arguing that losses would amount to no more than $40 to $50 billion, subprime was viewed by many in late-2007 as almost trivial in comparison to U.S. wealth in the many tens of Trillions. The market in "BBB" corporates has ballooned during this cycle to about $3.0 TN. With the U.S. economy and stock market booming, "BBB" has been viewed as virtually bulletproof. Well into 2008, "AAA" was bulletproof.

With major outflows from investment-grade funds, Credit availability is now tightening for the "marginal" "BBB" Credits. Tighter Credit conditions pressure GE and other borrowers that have for years feasted on the loosest finance ever. Heavily levered companies will face higher - in some cases significantly higher - rates when refinancing debt. This should mark a key inflection point for stock buybacks and M&A. These firms will also be vulnerable to the downside of the Credit Cycle, with deteriorating economic prospects and deflating asset prices.

Risk is high that huge quantities of "BBB" rated bonds will turn to junk ("fallen angels"). And as one issuers stumbles, a nervous marketplace will be fret the next victims of a rapidly tightening marketplace. Contagion at the "Core." In the event of a major liquidation, who will step up to buy?

November 16 - Fitch Ratings: "Fitch Ratings has downgraded PG&E Corporation's (PCG) and Pacific Gas and Electric Company's (PG&E) Long-Term Issuer Default Ratings (IDR) to 'BBB-' from 'BBB' and placed them on Rating Watch Negative… The rating action reflects the enormous increase in the size, intensity and destructive power of wildfires in California during 2017-2018, the implications of potential, vastly increased third-party liabilities under inverse condemnation and uncertainties regarding full and timely recovery of such costs.

How time flies. It's now been about six weeks since Chairman Powell's 'we're a long way from neutral at this point, probably." GE CDS has about tripled (83 to 259 bps) over this short period, while investment-grade corporate (Bloomberg/Barclays) spreads have surged from 105 to an almost three-year high 128 bps. Especially with this week's dramatic widening of corporate spreads, the Fed's attention has surely been piqued. A pullback in equities is not only unalarming to Federal Reserve officials, it's likely welcomed. The prospect of illiquidity and dislocation in corporate Credit sets alarm sirens blaring.

November 16 - CNBC (Jeff Cox): "The Federal Reserve is close to the point of being 'neutral' on interest rates and should predicate further increases on economic data, the central bank's vice chairman said Friday. Recent appointee Richard Clarida told CNBC's Steve Liesman that nearly three years of increases have brought the Fed's short-term interest rate near where it is neither restrictive nor stimulative, a key consideration when considering the future path of monetary policy. 'As you move in the range of policy that by some estimates is close to neutral, then with the economy doing well it's appropriate to sort of shift the emphasis toward being more data dependent,' Clarida said…"

Two-year Treasury yields sank 12 bps this week to 2.81%. Chairman Powell struck a balanced tone during his Wednesday evening presentation, falling short of the full retreat from relative hawkishness the market was yearning for. About 36 hours (and 50 bps added to GE CDS) later, vice chairman Clarida got closer to the mark.

I'll assume the White House similarly recognizes the rapidly deteriorating financial backdrop.

The President's Friday comments ensured a positive end to an ominous week.

November 16 - Bloomberg (Shannon Pettypiece and Shawn Donnan): "President Donald Trump said he is optimistic about resolving the U.S. trade dispute with China after receiving a response to his demands from Beijing, ahead of a widely anticipated meeting with China's Xi Jinping in Argentina… Trump told reporters Friday that the Chinese response was largely complete but was missing four or five big issues, signaling that tough discussions still need to take place between the two sides as they head into the Nov. 30-Dec. 1 meetings… "China wants to make a deal… They sent a list of things they are willing to do, which is a large list and it is just not acceptable to me yet. But at some point I think that, we are doing extremely well with respect to China.'"

President Trump added, "I don't want to put them in a bad position. I want to put them in a great position." This was a notably softer tone than the borderline gloating from a few weeks back (with Chinese stocks in a tailspin and U.S. equities hovering near all-time highs). I took exception with the President's approach back then. Not only would it surely enrage Beijing, I'm reminded of the old, "If you live in a glass house, don't throw stones". With Global Crisis Dynamics having landed at the Core, latent U.S. fragilities have begun bubbling to the surface.

This may motivate the administration to ink a trade deal with China. On the other hand, it may strengthen Chinese resolve. Beijing may see the advantage of playing long ball, believing their tightly controlled system is better prepared today to weather a global crisis than their U.S. competitor.

As for Global Crisis Dynamics, markets seem to turn more unstable by the week. There must be excruciating pain out there in the leveraged speculating community. The crude liquidation ran unabated this week, with (December) WTI sinking another $3.73 to $56.46. In a stunning move for such a major market, WTI is now down 25% from October 3rd highs ($76.72). And if you had a "pairs trade" long crude against a short in natural gas, you had a really miserable go of it. Natural gas traded to $4.93 intraday in Wednesday's session, up over 50% since October 3rd.

Speaking of pain, Italian 10-year yields were up another nine bps this week to 3.49%. And with German bund yields down four bps (0.37%), the Italian to German yields spread widened 13 to 312 bps. Italian banks were slammed 3.8%. Greece CDS jumped 24 bps to a near one-year high 417 bps. European periphery bonds were under pressure, with spreads (to bunds) widening 23 bps in Greece, eight bps in Spain and seven bps in Portugal.

While markets would like to take a constructive view of the less hawkish tone from Fed officials, there's little the Fed can do to sooth unstable markets. At this point, speculators are positioned for higher rates and yields. Sudden dovish talk sparks a reversal of hedges in the Treasury market, with sinking yields only exacerbating spread widening (and deleveraging) throughout corporate Credit. Five-year Treasury yields sank 16 bps this week. The unstable MBS marketplace saw benchmark yields drop 14 bps.

It's also a fair assumption that the speculators are positioned long the U.S. dollar, especially versus the emerging market currencies. Clarida's Friday morning comments heightened currency market volatility, with the dollar index declining 0.5%. The heavily shorted emerging equities (EEM) ETF rallied 2.8% this week. Rather ominously, Mexico didn't participate in the rally. Mexican equities sank 4.4%, as 10-year (peso) yields surpassed 9.0% for the first time in years. Mexico's CDS jumped 11 to 146 bps.

Here at home, Goldman Sachs CDS surged a notable 22 to 91 bps, the high going back to January 2017. Morgan Stanley (+13), Bank of America (+10), Citigroup (+10) and JPMorgan (+10) all posted double-digit CDS price increases this week.

But it was the 13 bps jump in investment-grade spreads (to 2-yr highs) that I place at the top of this week's notable market developments. The LQD investment-grade ETF closed Thursday at the lowest level since 2011 (negative 5.3% y-t-d return). So, my bearish imagination returns to the $3.0 TN of BBB corporate bonds. How much is held by investors that have little appreciation for mounting risks? How vulnerable are ETFs to a run? How much corporate Credit is held on leverage? Heavy leverage imbedded in derivatives? And is it outrageous to ponder the speculator community moving to deleverage, anxious to get out in front of a surge of ETF outflows?

Markets this week appeared to begin discounting a troubling scenario in corporate Credit. I believe we are also beginning to witness a historic inflection point with respect to economic structure. If a major tightening in financial conditions and corporate Credit Availability is now unfolding, then there are enormous numbers of uneconomic and negative cash-flow enterprises that face Rude Awakenings. As the New York Times put it, "General Electric may be the Canary in the Credit Market's Coal Mine."

November 16 - Bloomberg (Lisa Lee): "The U.S. leveraged loan market's benchmark price index dropped to a two-year low yesterday as credit and equity markets slumped. Besides negative vibes from the junk bond market, investors blame an increase in supply as issuers piled in to capitalize on robust demand for floating rate assets. 'We have these pockets where supply catches up to demand,' said Chris Remington, portfolio manager at Eaton Vance, one of the biggest U.S. investors in leveraged loans…"

Notable as well this week, new China Credit data.

November 13 - Reuters (Kevin Yao and Lusha Zhang): "China's credit growth slowed sharply in October, despite pressure by regulators on banks to help keep cash-starved companies afloat, pointing to further weakening in the economy in coming months. While October is typically a slow month for Chinese credit, growth in key gauges such as total social financing and money supply fell to record lows, reinforcing views that policymakers will need to step up efforts to revive flagging investment… Chinese banks extended 697 billion yuan ($100.23bn) in net new yuan loans in October…, much less than expected. Analysts polled by Reuters had predicted new loans of 862 billion yuan in October, down from 1.38 trillion yuan in September… Household loans, mostly mortgages, fell to 563.6 billion yuan from 754.4 billion yuan in September. Household loans accounted for 80.9% of total new loans in October, versus 54.7% in the preceding month…"

China Aggregate Financing dropped to 579 billion yuan ($84bn), down from September's 1.178 TN ($171bn), to the lowest monthly Credit expansion since July 2016 (479bn yuan). Estimates were at 1.300 TN yuan. After 10 months, y-t-d Aggregate Financing of $1.925 TN ran 20% below comparable 2017. And while new bank loans slowed sharply from September (and recent months), it was still up somewhat from October 2017. Consumer Bank Loans slowed in October, although were still 25% above October 2017. Year-to-date new Bank Loans were up 17% from comparable 2017 (y-t-d Consumer loans up 18%). Meanwhile, "shadow bank" lending contracted (268bn yuan) in October.