Credit Writedowns Daily Newsletter 2018-10-03

There are a lot of different things on my radar screen right now. And below is the list of news items I want to touch on in that context.

As I’ve been saying recently, I’m fairly bullish on the US economy and US market despite shares being overvalued. Economic growth in the US continues to outperform the developed world. And that’s been positive for the stock market, which reached another record high today.

I am less positive about the rest of the world than the US. But I don’t see any cause for alarm, including in Italy. We are a fairly long way off from recession. And the credit cycle has yet to turn. I’ve been saying it would turn in 2019. When, after that, a recession happens is anyone’s guess.

1 – Almost Junk

Because high yield companies have more precarious balance sheets, they can be a early warning sign of distress. For example, high yield started to get hit many months before the S&P 500 peaked after the housing bubble in 2007. But, investors love high yield right now. According to CNBC, the iShares iBoxx High Yield Corporate Bond ETF was second amongst all ETFs last quarter for bringing in new money, trailing only the iShares S&P 500 ETF. And the lower the bond rating, the better the performance has been.

Interestingly, about a week ago, James Mackintosh ran a piece on the increasing number of companies rated BBB, which is one notch above high yield. He noted that not only do these ‘almost junk’ bonds represent 40% of the corporate bond market, but the option-adjusted spread for investment grade bonds was up 25 basis points from their lows.

So, in a situation where the market turns down, many of these companies could turn into fallen angels, making these companies a universe to watch. And this is especially so since covenant-lite loans account for 79% of leveraged loans, up from 55% in 2014. That’s another area besides high yield and ‘almost junk’ to look for distress. IMoody’s warned in August about covenant-lite loans, saying “average U.S. first-lien term loan recoveries would fall to 61%, versus their 77% long-term historical average. For the second lien, recoveries could be 14%, compared with a 43% historical average.” Caveat Emptor

And, because of the Fed’s policy normalization, the average interest rate on leveraged loans has risen about one full percentage point in the last year to 5.5%. More rate hikes,will mean higher interest rates and the potential for distress.

2 – Amazon and the $15 an hour wage floor

I saw that Labour Deputy Leader Tom Watson was tweeting about Amazon’s decision to raise its wage floor in the US and the UK.


Basically, Amazon is anti-union. And so from Watson’s perspective the wage floor increase isn’t enough. He wants organized labor to have more power to bargain on behalf of workers. No one is talking about that in the US. Instead, people are saying, this move – along with Walmart’s earlier wage increase – will create a ripple effect for low wage jobs at places like fast food companies and retailers. If that’s true, expect this current cycle to have legs, as wages are the underpinning for sustainable growth. And that means the Fed’s rate hike cycle will lengthen, with the concomitant negative spillover into almost junk and high yield markets.

3 – The loss of trust abroad in Trump’s America

In the latest poll from the Pew Research Center, Trump’s international ratings are abysmally low, especially with key US allies. Here are the numbers:

US opinion abroad.jpg

Only three countries think better of the US under Trump than under Obama: Russia, Kenya and Israel.

What will this mean for US soft power? If you read the nuances of the poll, there isn’t anywhere for a lot of US allies to turn. This part struck me:

In addition to being asked about whether major powers are rising, falling or staying about the same, respondents were asked the following question about whether they would prefer the U.S. or China to be the top global power: “Thinking about the future, if you had to choose, which of the following scenarios would be better for the world: the U.S. is the world’s leading power or China is the world’s leading power?” Results show that the U.S. is overwhelmingly the top choice.

The U.S. is named more often than China in every country surveyed except three: Argentina, Tunisia and Russia, although in many nations significant numbers volunteer that it would be good for the world if both or neither were the leading power.

And we know countries don’t want Russia as an alternative to the US either. So, on one level, trust in the US is down. But there are really no alternatives. So on the longer-term basis, I question whether countries will turn meaningfully against the US. Maybe they will grin and bear it, waiting for Trump to leave office.

No matter what happens, remember that the standard macro position of political analysts is that Trump is damaging US interests abroad. The Pew poll says that his low ratings may not translate into discernible change in policies. So, Trump may, in fact, have no long-term negative impact on US foreign policy interests. Something to think about

4 – Kavanaugh

I’ve been wasting a lot of time tweeting about US Supreme Court nominee Brett Kavanaugh because his obvious lies are galling to me. Let me spell out what I think this means longer term in bullet point format.

  1. The US is polarized in large part because the two main parties have no overlap ideologically. This is a shift that has been happening gradually over the last 40 or 50 years. Gone are the Rockefeller Republicans like Nelson Rockefeller and John Lindsay. And gone are most of the Blue Dog Democrats.
  2. The result of the polarization is politicization of nearly everything including the Supreme Court nominations. For example, Ginsburg was confirmed 96-3 in 1993. But since that time, it’s been ever more partisan. Breyer had 9 no votes and Roberts 22. But no votes increased dramatically afterwards: Alito 42, Sotomayor 31, Kagan 37, and Gorsuch 45.
  3. The blocking of Merrick Garland’s nomination for over 300 days was an incredibly partisan maneuver and set the stage for intense acrimony under Trump, one reason for Gorsuch getting 45 no votes.
  4. Kavanaugh is the culmination of this polarization and politicization in particular because he is a clearly partisan individual, having been a Republican operative in the 1990s and 2000s before being gifted a judgeship under Bush. His partisanship was stunningly clear in his opening prepared remarks last week.
  5. Kavanaugh’s partisanship alone is disqualifying. But his lying about numerous minor and big issues – from stolen emails, knowledge about Judge Alex Kozinski’s harassment, and his own drinking habits – is also disqualifying.
  6. If Kavanaugh gets through onto the court, no 5-4 decision, on which he is on the winning side, will be seen as legitimate. The court will effectively have been so politicized as to be rendered illegitimate in the electorate’s eyes. This is very dangerous stuff.

So, going forward, we will have extreme partisanship, cries about illegitimacy of the President and the Supreme Court, with an elected Congress that is highly unpopular. That does not speak well to the likely political outcomes.

That’s all I’ve got for now. I would love to hear your comments on Kavanaugh.

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