Perspective on Risk - July 1, 2022
Fed Tightening; Risk Premia; GDPNow; Credit Spreads; Inflation; Japan; The First Global Credit Crisis; Jay Newman on EM; Compliance; Does the G in ESG Matter; Operational Risk
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9.62% Yield on TreasuryDirect iBonds (annualized)
1.15% Projected Annualized 10 year equity return (CAPE)
Fed Tightening
Back to real markets.
Here is a graph of the Fed’s asset holdings; the Fed’s holdings ballooned from around $4T to $9T with their response to covid. This increase is the equivalent of just under 25% of annual GDP. The Fed monitized about half of the last three years; fiscal deficits and added another $2.7T of MBS to their balance sheet.
The Fed has begun to allow treasuries and MBS to roll off the b/s. UST is to shrink by $30B per month, and MBS by $17.5B, and this pace will double in September. This will reduce the Fed’s b/s by about a third in three years; if all goes well, this level will still be in excess of the pre-covid peak. This additional supply is in addition to the apx. $1T deficit that the US is projected to run this year.
Companies and consumers have essentially benefitted from a subsidized cost of capital for over a decade; this is their ‘normal’ and I suspect neither are ready for a decade where the cost of debt and equity will be elevated.
Cost of debt will rise as Fed increases rates; equity risk premium should widen as higher yields on low risk assets lead to rebalancing away from the highest risk assets.
Graph courtesy of @DomWhite
Risk Premia
Aswath Damodaran, the widely respected NYU academic that tracks equity risk premium, has a new post Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back? A couple of highlights:
The big story, related to COVID, is that risk capital not only did not stay on the side lines for long but came surging back to levels that exceeded pre-COVID numbers
The first half of 2022 has been a trying period for markets, and as inflation has risen, it is having an effect on the availability of and access to risk capital. There has been a pullback in all three proxies for risk capital, albeit smaller in venture capital, than in IPOs and in high-yield bond issuances in the first few months of 2022. That pullback has had its consequences, with equity risk premiums rising around the world.
Not only has the implied ERP surged to 6.43% on June 23, 2022, from 4.24% on January 1, 2022, but stocks are now being priced to earn 9.45% annually, up from the 5.75% at the start of the year.
The big question that we all face, as we look towards the second half of the year, is whether the pullback in risk capital is temporary, as it was in 2020, or whether it is more long term, as it was after the dot-com bust in 2000 and the market crisis in 2008. If it is the former, there is hope of not just a recovery, but a strong rebound in risky asset prices, and if it is the latter, stocks may stabilize, but the riskiest assets will see depressed prices for much longer. I don't have a crystal ball or any special macro forecasting abilities, but if I had to guess, it would be that it is the latter.
Finally, at the risk of sounding callous, I do think that a return of fear and a longer term pullback in risk capital is healthy for markets and the economy, since risk capital providers, spoiled by a decade or more of easy returns, have become lazy and sloppy in their pricing and trading decisions, and have, in the process, skewed capital allocation in the economy.
Recession? GDPNow Has Fallen Off A Cliff
Credit Spreads Are Widening
IG Spreads are now rapidly widening
High yield spreads have widened, but are not yet near crisis highs. This may represent a ‘normalized’ level for the next few years.
Leveraged loan issuance is down, mirroring investor demand. ‘Institutional’ leveraged loans are particularly down; these feed the CLO market, which will face particular pressure from a greater supply of UST.
The tide has just started to recede.
Inflation
If I told you that 5 year break-evens were flat to down for the YTD, would you believe me?
Eurodollar curve is down inverted; the market keeps pulling forward Fed action.
Adam Hale Shapiro of the SF Fed published a nice note How Much Do Supply and Demand Drive Inflation? that concludes:
Supply factors explain about half of the difference between current 12-month PCE inflation and pre-pandemic inflation levels, and the effects appear to be rising more recently. Demand factors are responsible for about a third of the difference, and those effects appear to be diminishing more recently.
The large impact of supply factors implies that inflationary pressures will not completely subside until labor shortages, production constraints, and shipping delays are resolved.
Fed Board economists have published Bottlenecks, Shortages, and Soaring Prices in the U.S. Economy concluding similarly:
[B]ottlenecks and inflation during the pandemic were importantly driven by the very strong and rapid expansion of demand during the initial economic recovery combined with an unprecedented re-allocation of demand across sectors and reduced supply capacity, prompted in part by sharp declines in labor force participation. Looking ahead, the resolution of bottlenecks will depend crucially on an easing of consumer goods demand, which may follow from a return to the pre-pandemic mix between goods and services. The resolution will also depend on the recovery in labor force participation, which can support short-run supply, and strategic investments that can expand longer-term production capacity. If all these developments are realized, we may see a slowdown in overall inflation even as the economy continues to grow.
Finally, OddLots again had another timely and informative interview, this time a follow-up with Viktor Shvets of Macquarie Capital.
[W]e have been suggesting that investors face a pendulum, with the macro environment violently swinging between strong inflationary spikes and equally deep disinflationary collapses. The reason for this is that unlike the previous 25 years, we now have both disinflationary and inflationary forces at work, with the balance between the two determined by government action (principally intensity of fiscal and redistribution spending) and frequent appearances of ‘fat tails’ (healthcare to geopolitics).
We maintain that monetary policy will start changing toward the end of 2022, accelerating in 2023, starting with communication but then progressing to rates cuts and conversion of quantitative tightening back to quantitative easing.
Japan
Japan is forging ahead with plans to buy up vast quantities of bonds in a bid to support the country’s economy, drawing a stark contrast to other major countries that are exiting stimulus programmes, writes Nikou Asgari.
The Bank of Japan will buy about ¥10tn worth of bonds in June — roughly equal to the US Federal Reserve scooping up $300bn worth of debt per month when adjusting for gross domestic product, according to Deutsche Bank calculations.
Policymakers in Tokyo are pursuing the bond-buying programme as part of a plan to keep a lid on medium-term costs known as yield-curve control that has been in place since 2016. The scheme’s continuation pushes Japan far out of line with even its most dovish global peers, such as the Swiss National Bank that this week surprised markets with its first interest rate rise in 15 years.
“This is an extreme level of money printing given that every other central bank in the world is tightening policy,” said George Saravelos, head of European foreign exchange strategy at Deutsche.1
The First Global Credit Crisis
A few of our friends over at NY Fed wrote this nice little Liberty Street blog post: The First Global Credit Crisis.
June 2022 marks the 250th anniversary of the outbreak of the 1772-3 credit crisis. Although not widely known today, this was arguably the first “modern” global financial crisis in terms of the role that private-sector credit and financial products played in it, in the paths of financial contagion that propagated the initial shock, and in the way authorities intervened to stabilize markets.
Jay Newman on Emerging Markets
Odd Lots killing it again with timely guests. Here is a link to Jay Newman on the Coming Crisis for Emerging Markets. Hears the teaser:
I think it's almost the perfect storm for EM. And the only real comparison I can draw is from the very beginning of third world debt crises, which is the eighties
China's a huge lender, an investor in developing countries, but no one knows how big they are. … I don't think even the IMF has a clue what the scale of those investments are
China, which doesn't want to take a discount at all. … they're implacable foes on many levels, but particularly when it comes to the debt … can you imagine sitting down at a negotiating table with a group of creditors …. Everyone's documents are on the table, except for China. So you have this huge force, you know, in the room and outside the room that won't tell you how much they owe and isn't willing to take a discount to make things fit together. So it's almost, in that climate, it actually becomes, in my view, impossible to have restructurings that really get countries out of the woods and put them on a strong financial path
[W]e really can't talk enough about China and the role of China in developing economies on every level, from the perspective of controlling natural resources, from the perspective of being a direct foreign investor, from the perspective of being a lender. China will be the dominant question for the next several decades
Compliance
Switzerland’s Federal Criminal Court Monday fined Credit Suisse two million Swiss francs for failing to stop an employee who allowed a criminal organization to launder money through the bank. It also confiscated 12 million francs from Credit Suisse accounts linked to money laundering.
[U]nder Swiss law, local prosecutors can press criminal charges against banks if they believe those institutions didn’t do enough to screen clients and their cash for obvious ties to illicit activity. Credit Suisse Hit With Historic Money Laundering Conviction (Bloomberg)
I haven’t been able to find a link to the indictment for y’all. Interesting to see the repercussions; the US regulators have historically been very reticent to indict firms due to knock-on effects, like ERISA restrictions. Switzerland’s attorney general has traditionally quietly used proceedings meant for minor transgressions to high-stakes cases.
Deutsche Bank CEOs undermined AML systems to keep ultra-rich, but risky clients
A complaint alleging that top Deutsche Bank executives overruled compliance staff to keep or continue relationships with rich, but risky clients, such as Jeffrey Epstein and Russian oligarchs survived dismissal. According to the complaint, Deutsche Bank's former and current CEOs were personally involved in securing relationships with very rich but high-risk clients for the bank's wealth management business and that these clients were essentially not vetted at all.
The court found that that the complaint adequately alleged that the CEOs know about the deficiencies in the banks practices that made their statements false and misleading (Karimi v. Deutsche Bank Aktiengesellschaft, June 13, 2022, Rakoff, J.).
Deutsche Bank first argued that the challenged statements were merely aspirational or puffery. The court disagreed, finding that the statements went beyond mere puffery because they provided specific descriptions of the bank's client-vetting processes and continuous monitoring that the complaint alleged were routinely ignored or did not exist in practice for certain high-net-worth and politically connected clients.
Deutsche Bank then asserted that its failures were already well-known to investors. … The court rejected the suggestion
Stay tuned.
Does the G in ESG Matter to Clients?
The Securities and Exchange Commission today charged Ernst & Young LLP (EY) for cheating by its audit professionals on exams required to obtain and maintain Certified Public Accountant (CPA) licenses, and for withholding evidence of this misconduct from the SEC’s Enforcement Division during the Division’s investigation of the matter.
EY admits that, over multiple years, a significant number of EY audit professionals cheated on the ethics component of CPA exams and various continuing professional education courses required to maintain CPA licenses…
EY further admits that during the Enforcement Division’s investigation of potential cheating at the firm, EY made a submission conveying to the Division that EY did not have current issues with cheating when, in fact, the firm had been informed of potential cheating on a CPA ethics exam.
If I were still actively employed, I’d be insisting on getting management and the Board on the record if they want to continue to employ E&Y and the CPA firm. But I’m a hard-ass on this governance stuff.