Bottoms-Down Forecasting

Griswold, Bottoms-down forecasting

What do bad wiring, methane and non-chloric, silicon-based lubricant have in common?

Presumably a classic Christmas movie would not first come to mind. It’s a Wonderful Life and Miracle on 34th Street, those are true classic masterpieces. In more recent movie history, A Christmas Story and Home Alone have captured the rowdier spirit of the season.

That leaves National Lampoon’s Christmas Vacation a close fifth for some as a must watch, at least among the non-animated classics. Favorite scenes compete for top spot in this less-than-high-brow comedic tale; two of these star animals. In the first, a cat chewing Christmas tree light wires ends fatally for the feline. This side-splitting scene was almost cut by the PC police, which just goes to show you. In the second scene, an indoor squirrel chase also delights; the culmination of a hilarious series of events that features methane gas and Cousin Eddie, perhaps the best redneck character to ever grace, if such terms as redneck and grace can reside together, the big screen.

And then there’s the infamous downhill sled scene. In endeavoring to achieve a “new amateur, recreational, saucer-sled land-speed record,” Clark Griswold, played perfectly by Chevy Chase, waxes a steel sled with a kitchen lubricant. The fiery end in a Wal-Mart parking lot is truly one for the ages. With Christmas being over, it seems a shame to store these moments with everything else that comes out for the Holidays and won’t be seen for another long year.

But look ahead to the New Year we must. Wall Street has been doing just that for the better part of the last month. Barron’s recently characterized the Street’s 2016 outlook as, “Cautious, but Optimistic.” The group’s mean forecast places the benchmark Standard & Poor’s 500 stock index at 2220 by the end of next year, roughly six percent above current levels.

Of course, the optimistic predictions are on par with those being espoused at this time last year that have not panned out as prognosticated. But the optimism is to be expected. With rare exceptions, strategists are a sanguine lot, as they should be. After all, they’re tasked with keeping their firms’ clients’ money fully invested (and therefore fully fee-generating).

Given his constructive posture, Goldman Sachs’ David Kostin is this year’s standout among Barron’s ten cited strategists. His 2,100 yearend S&P 500 target is the lowest of the bunch. His outlook is weighed down by the view that the Fed will hike rates four times in 2016. This will in turn drag down what will otherwise be decent earnings against the backdrop of yet another year of tepid economic growth.

Citigroup’s Tobias Levkovich, a friend and investing legend in his own right, is characteristically optimistic. His Barron’s forecast lines right up with the consensus: The S&P will end next year at 2200. That upbeat take makes his downside risks all the more intriguing as they tap the contrarian in him. Tellingly, they begin with upside risk to the employment and wage picture which triggers a “chase towards higher bond yields.” This chase would catalyze what policymakers fear more than wage inflation; that is wide scale bond fund withdrawals which exacerbate illiquidity and trigger further financial market tightening.

Policymakers have good reason to be concerned: U.S. credit mutual funds have doubled since 2010 and now own a fifth of the market; retail investors have poured over $1.2 trillion into credit mutual and exchange-traded funds since then. The last thing portfolio managers need at this juncture is greater constriction on their ability to trade their holdings.

The real question is whether the long-anticipated rise in wage inflation is really around the corner. That would be a good problem to have for many Americans. While jobless claims would have many believing the arrival of higher paychecks is imminent, layoff announcements are poised to end the year up by nearly a third over 2014. In other words, the lowest commodity prices in 16 years will continue to exact a macroeconomic toll; the damage is unfolding with a lag as many companies (and countries) have banked on a rebound in energy prices.

The conventional wisdom heading into 2016 is that the economy is finally poised to reap the benefits of lower gasoline prices; oil prices have fallen so far they no longer have the ability to do incremental harm. Fresh data on home sales in energy dependent states, though, defies this conclusion as the fallout appears to be intensifying. Punctuating the latest stats on housing, the outlook in the just-released Dallas Fed manufacturing survey tumbled to its bleakest levels of the past year, matching lows last seen in 2009.

Meanwhile in the Midwest, the prognosis for the Chicago region refuses to break into positive territory. This can’t be comforting given the auto sector’s outsized positive influence on the current recovery. The dour outlook does, however, help explain the fact that the number of cars sitting in inventory vis-à-vis sales levels is at the highest since 2009.

The credit markets, for their part, are shooting first and presumably taking questions at a later date. What’s spooked them? In bond land, investors rely on the distress ratio to guide them, that is the number of high yield bonds trading at yields 10 percentage points or more above comparable-maturity Treasury bonds. As of November, one-in-five companies were in this leaky boat, the highest showing since 2009.

The distress ratio is seen as a precursor to the more definitive default rate, when companies actually renege on their interest payments. For now, the rate is just north of three percent, not high enough to set off any alarms. But forecasts are calling for it to push five percent next year fueled by energy company defaults, which are expected to spike to 11 percent.

A bit of context: Though the rate itself will remain historically low, the dollar amount of failing debt is expected to rise to $66 billion, close to 2001’s $78 billion but still a fraction of 2009’s record $119 billion. If only the credit markets existed in a vacuum. Roll the rest of the world’s debt markets into the equation and defaults have indeed risen to the highest level since 2009.

In the event the repeated mention of 2009 has given you a case of the jitters, fear not. At least that’s what New Albion Partner’s Brian Reynolds advises. Reynolds, who tracks public pensions’ penchant for risk taking, provides assurances to the leery in the form of a running tally of pension allocations to credit funds.

Reynolds’ figures grace these pages with frequency for good reason, namely that pensions have a lot more cash to throw around than most – as in $18 trillion. With the latest month’s count in hand, it’s official — pension allocations to credit funds hit monthly records in August, September, October, November and now December. In all, some $175 billion earmarked to fund current and future retirees’ income has flooded credit funds since August 2012. With the trend continuing apace, demand for all manner of credit promises to continue burying supply, propping up a market that should be toppling over.

As simple as the argument is, Reynolds could be on to something. If he’s right, recession may not greet the next president proving the cheery prognosticators at the Congressional Budget Office right. At the start of this year, the CBO predicted that the current recovery would last, at a minimum, through the end of 2017. Maybe the CBO has also been following pension behavior and knows that financial engineering in the New Year will remain alive and well.

If only this could end as well as a feel-good Christmas movie. For now, policymakers are looking the other way. What say could they possibly have in the matter, even if they did acknowledge that pensions are using neither a bottoms-up or top-down methodology to test the appropriateness of their portfolio allocations? Besides, party poopers have no place as New Year revelers gear up for one last hurrah.

But what if 2015 really is akin to 1998, and not 1999, for investors? What if this rally has legs and can keep recession at bay? Well then, we position our collective portfolios to profit at the expense of irresponsible pensions employing a bottoms-down approach, Griswold-style. The fact that they’re placing pensioners’ promised paychecks at grave risk of spontaneous ignition can be relegated to denial-ville as so many seemingly intractable issues are today.

Whistling Past the Junkyard

To this day, I still count by the flash of lightning and the thunderclap to guesstimate a storm’s distance. To this day, I make sure all trees are trimmed to be absolutely positive they’re clear of any window in my home. Such is the impression Poltergeist left on yours truly’s psyche back in 1982. For those of you who need reminding, Robbie, the name of the character who played the son in Poltergeist, would count the seconds between the lightning and the crashes of thunder for comfort knowing that the longer the pause, the more distant the storm. In the end, as the unsettled spirits rose through the floorboards beneath which they were buried, the time spans grew frighteningly shorter, culminating in Robbie’s being snared right out of his bedroom by a possessed tree. Though Robbie was rescued from the storm’s grasp, his fictional sister Carole Anne was not so lucky. The demons in the TV grabbed her very body and soul and didn’t let go until her determined mother went into the netherworld to get her back.

For the credit markets, the storm sounds as if it’s closing in. In a genuinely spooky “They’re here” moment, just last week, Zerohedge broadcast the news that the UBS Managed High Yield Plus Fund had announced it would be nailing the doors shut and liquidating their holdings. Slowly. The doomsday blog warned that the illiquidity Minsky moment was finally knocking on hell’s door; big banks’ bond inventories have been decimated and funds’ ability to liquidate in an orderly fashion would be stress-tested and fail. Forget for a moment that UBS is also the name associated with the first stressor to emanate from the burgeoning subprime crisis. This fund, which opened to investors in 1998, had survived both the dotcom bubble bursting and the credit collapse that accompanied the subprime crisis.

There’s no doubt the time should be nigh. Credit spreads, a measure of the extra compensation over Treasurys investors command for the risk of taking on corporate credit risk, for both high grade and junk bonds have gapped out in recent months. Investors are now demanding seven percentage points above comparable maturity Treasurys to hold the riskiest credits, the most in three years. Though nowhere near their post-crisis highs that exceeded double-digits, spreads are nonetheless flashing red. They’re cautioning investors that the distress emanating from commodity-dependent global economies and signs of a slowing U.S. economy could create enough turbulence to derail one of the most glorious credit cycles in the history of mankind.

Aside from macroeconomic indicators, what exactly are spreads tuning into? A recent report by Deutsche Bank’s Oleg Melentyev, whom I’ve known long enough to spell his last name by heart, suggest that the stage is set for the next default cycle. For starters, the current credit cycle is pushing historical boundaries. Going back to the 1980s, high-yield debt creation waves have lasted between four to five and a half years resulting in 53-68 percent debt accumulation from the baseline starting point. Where are we in the current cycle? Over the past four and a half years, junk credits have tacked on 55 percent growth when you take into account the combination of bonds and leveraged loans on bank balance sheets, putting the cycle, “comfortably inside the range of previous cycles,” according to Melentyev.

But that’s just one omen. Issuance aggressiveness is another way to test the credit cycle winds. Cumulative credit cycle issuance volumes of companies rated CCC and below, the junkiest of the junk, half of which can be expected to default over the next five years, casts a light on investors’ true pain thresholds. The mid-1990s and the mid-to-late 2000s saw highly toxic issuance swell by 20- and 18-percent, compared to the current cycle’s 17 percent.

Melentyev hedges the two metrics’ signals with the caveat that he’s using 2011 as a starting point despite clear evidence that the markets were expanding by the latter half of 2010. Erring on the conservative side, in other words, leads him to the ominous conclusion that, “the pre-requisites for the next default cycle are now in place.” Pre-requisites, though, do not make for certain outcomes though other fundamental benchmarks validate Melentyev’s premise.

At the most basic level, companies reassure bond investors by demonstrating they can cover the coupon they’ve promised can be clipped. The higher a company’s credit rating, the greater the probability the firm can make good on its commitment. The question is, what does it say when the presumptive pristine credits that populate the investment grade universe, the ones who disdainfully look down their noses at their lowly junk-rated brethren, begin to emit signs of balance sheet stress? The ratio of debt-to-earnings before interest, taxes, depreciation, amortization and whatever else is left in the kitchen sink for this superior cohort rang in at 2.29 times in this year’s second quarter. That tops the 1.91 clocked in June 2007 before the onset of the financial crisis. So a less cushioned starting point – that is, if this is the starting point and the storm really is fast approaching.

There are plenty of guideposts that indicate we haven’t yet arrived at the beginning of the end. Topping the list is the furious merger and acquisition (M&A) activity dominating the news flow. At $3.2 trillion globally, 2015 was already on track to take out the 2007 record of $4.3 trillion in M&A volume. And then the big guns came out. Michael Dell’s ambitions as a private market tech mogul became crystal clear with the announcement that Dell, partnered with Silver Lake, would take out EMC in a $63 billion transaction that requires at least $40 billion in debt to finance. The kicker is that $15 billion would be junk bonds – the biggest of its kind in history.

To not be outdone, Anheuser-Busch InBev muscled in to buy SAB Miller with a sweetened $106 billion offer giving new meaning to “This Bid’s for You!” As for the financing to consummate this tie-up? A cool $70 billion in debt financing, a figure that tops Verizon’s one-for-the-history-books $49 billion in bonds that helped pay for its acquisition of Vodafone.

In the event these figures have induced a bit of debt indigestion or indignation, rest assured, Standard & Poor’s (S&P), that other mighty credit rating agency, is on the case. In the first nine months of the year, S&P downgraded companies 297 times, the highest pace since that dark year 2009, with liquidity in the bond market one-tenth what it was, caveat clearly emptor.

And yet…there’s that sticky issue of the dumb money that’s on the prowl. This is not some reference to a pile of mutual fund “money on the sidelines,” which history has proven can be as ephemeral as a poltergeist you wrongly conclude has been exorcised. Nope – we’re talking about brand-new allocations to the credit markets.

Brian Reynolds of New Albion Partners, whose name has graced these pages in the past, helpfully keeps a real time score of the number of public pensions allocating fresh funds to the credit markets since August 2012. His most recent reckoning: 782 votes amounting to $169 billion in new monies being put to work in credit funds. Assuming a conservative five times leverage (which beats the 10-50 leverage multiples deployed in pre-crisis days), some $1.2 trillion in new credit flows have goosed the debt markets since late 2012.

What, pray tell, do stock market gyrations the likes of which we’ve seen since August do to pensions’ collective pain thresholds? In a nutshell, it strengthens their resolve to diversify, diversify, diversify away from their stock market exposure. August, September and the first half of October have set a three-month record for new pension allocations. Taking the cake in the “you-just-can’t-make-this-stuff-up” category, the Louisiana Firefighters’ pension is putting $50 million to work in an unconstrained fixed income fund; the funding will be sourced from an equity fund liquidation. On second thought, maybe it’s a good thing they’ve got access to plenty of firehoses.

Looking ahead, Moody’s high yield soothsayer Tiina Siilaberg, (I can spell her name from memory as well), sees clear evidence that refunding risk is building in the pipeline. Tiina’s barometer is the credit rating agency’s proprietary index that gauges the future ability of companies to roll over their maturing debt in three years’ time. The last time this indicator was at its current level was in the depth of the 2009-2010 credit crunch. “A significant contributor to the decline in the index is the increase in upcoming maturities. We currently expect $109 billion of speculative-grade bonds maturing over the next three years vs. $88 billion at the beginning of this year.” Indeed, refinancing volumes are down by some 37 percent over the last year.

Eric Rosenthal, at Fitch, which rounds out the Big Three credit rating agencies, foresees some messiness in the statistics to come thanks to the degradation of issuer balance sheets coupled with the less-than-friendly refinancing landscape. Rosenthal, whose last name practically spells itself, now expects the corporate bond market default rate will end the year around 3.5 percent and keep moving up in 2016. This rate, he cautions, is materially higher than the 2.1-percent average rate that coincides with non-recessionary times. In an conscious nod to $45 oil, nearly half the energy and metals & mining issues are trading below 80-cents on the dollar (par is 100-cents) compared to seven percent for the whole of the high yield universe. Still, the beat goes on, Rosenthal concedes – which is good news for Michael Dell. Issuance may be down 35 percent over last year for the aforementioned beleaguered commodities space but it’s up three percent for the rest of the junk market.

Are the conditions for a meltdown in the bond market firmly in place? Are investors deluding themselves, whistling past the junkyard? Absolutely. But that shouldn’t necessarily keep you up at night, counting the seconds in between lightning flashes and thunderclaps. Or, as Deutsche Bank’s Melentyev’s quips, “A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so.” By that same token, Poltergeist’s greedy real estate developer could have ponied up the extra moola to move the coffins of the dead and buried under the subdivision he so profitably erected. Instead, he rolled the demonic dice and simply removed the headstones, whistling past the houses until the unsettled corpses rose through the floorboards, shattering the illusion of suburban serenity.