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Monday, 23 October 2017

On massive volumes and squeezes on leverage

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Anthony Peters deals with his angst over the build up of risk.

I have little doubt that market chatter today will be abuzz with the FT report this morning that US deal-making has hit a new monthly record of US$243 billion in May. That’s a lot of money in anybody’s book although even I can tell that it’s not “index adjusted”.

The article cites the deal volume in May 2007 as US$226 billion and in January 2000 as US$213 billion but the S&P currently stands at 2,111.73 points as opposed to being in the mid-1,500s in Spring 2007 in the mid-1,400s in early 2000 so the new record of US$243 billion isn’t really a record at all, other than in nominal value.

I suppose the dedicated punster would have to look at the news and wryly and dismissively comment “Big deal!” But that is not the essence of the story. We are back to cheap leverage, big deal-making and a flood of the kind of collateralised loan obligations which punctuated the periods before the markets blew up first in the bursting dot.com bubble and then again during the global financial crisis.

I am on record as a defender of the CLO, as opposed to the CDO, as a vehicle for funding more highly-leveraged borrowers but when the CLO community begins to believe that it is making M&A activity possible and the M&A community thinks that it is to be thanked for creating high-yielding credit products for the structuring desks, you know it’s not looking healthy.

The central banks have over the past seven years done more than their bit towards driving recovery by way of quantitative easing and loose monetary policy but the time has come for them to also acknowledge that they are contributing to a build-up of risk in the portfolios of yield hungry investors which could quite easily lead to a repeat of the massive corrections of either 2000 or 2008 or, if the stars align, both at the same time.

It’s the liabilities…

I was, incidentally, also talking to my old chum Alex Moffatt of Joseph Palmer & Sons in Melbourne who happened to be preparing a talk he will be giving later in the week. He also commented on the amount of leverage which has been built up again since the dark days of the Lehman failure. Lehman, of course, went under as a result of the implosive withdrawal of leverage – we need to remind ourselves from time to time that the crisis of 2007/2008 was one which was created on the liability side of the balance sheet, not on the asset side – and this could quite easily happen again.

The feature of a squeeze on leverage and hence on investors’ ability to hold stock is the inevitable need to sell which, given both the unwillingness and the inability of what were once called “market makers” to absorb the flood of selling will be gapping markets. We saw an example of that in the Bund market last month and in the Chinese stock markets last week. That the Shenzhen dropped over 7% from an intraday high of 3,067 points to close at 2,757 points on Thursday is one thing. That it dropped to an intraday low of 2,641 points on Friday morning is another thing but that it is today a full 14½% higher than that low and is trading, at the time of writing, at 3,025 points, a new all-time high is altogether something entirely different.

I had thought that the Chinese authorities had decided to get a grip on this blind speculation but I must have been wrong. US equities are considerably more sanguine, thank heavens, but that does not mean that they are not also living on borrowed time.

There is a growing consensus the Federal Reserve will be pulling the trigger in September and if I were a member of the FOMC and were to see the FT pieces - not that I wouldn’t have previously been aware of just how gung-ho the M&A business is again – I would strongly feel the need to put on the brakes. Maybe, and I’m not being frivolous here, that is precisely why Janet Yellen has chosen to avoid the lime-light at the Jackson Hole caucus.

Hellenic Hole

Meanwhile, that little matter of the Hellenic Republic; there was yet another summit on the subject in Berlin yesterday except that this one was also attended by Saint Mario in person.

I am getting the sense that the powers that be are beginning to fear their own courage when it comes to bringing Athens to heel and that they must have been burning the midnight oil in order to find a way of letting them off paying their debts without a default having to be declared. I suppose that, in the aftermath of the GFC, centuries old rulebooks on the process of borrowing and lending have been torn up – I’m thinking of the invention of “bailing in” – so going one step further and finding another way of excusing a creditor from not meeting his obligations because it doesn’t suit the imaginary backdrop of sunshine, blue skies and green pastures with grazing sheep and a pretty shepherdess should surprise none of us. As the late, great Robin Williams had it “Reality; what a concept!”

Green shoots of inflation

Today is Eurozone PPI day and a small plus is expected for the April month over month release. Economic stats are altogether beginning to look more encouraging. Whether this is due to or despite the ECB’s QE programme is a moot point but the news, should it emerge as anticipated, should please.

Did I ever think I’d live to see the day when rising inflation was going to be celebrated as though it was a lottery win?

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