06 Mar Party Like It’s 1999 (Q1-18)

“We are having a party at Apollo these days”, Jim Zelter, co-President. Apollo Global Management at 2018 Milken Institute Global Conference.

Similar to the end of the 1990s expansion, investors today are juxtaposing a strong global economy with a nearly 10-year-old bull market in risk assets that refuses to quit. The S&P500 is currently trading at 14X EBITDA, which surpasses the previous peak in this multiple in 1999. Back then, occasional bouts of volatility and widening of credit spreads could not stop the animal spirits from creating excessive appreciation in equity and credit markets. Tech stock prices nearly tripled in 1999 and five-year earnings growth estimates from analysts averaged an incredible 18% per year. The unemployment rate fell from 4.3% to 4% by the end of the year. The U.S. Federal Reserve (the “Fed”) declared the U.S. economy to have reached full potential but only gradually rose rates from 4.75% in June 1999 to 6.5% in May 2000. When financial conditions finally tightened, the economy contracted, the U.S. fell into recession, and the adjustment to equity and credit markets was more rapid than expected.

When central bankers cut rates to extremes, market speculation and excessive borrowings are inevitable. So is the pain that comes from the reversal. Today the Fed is unable to ignore wage pressures from an economy that has reached full employment and is (again) reluctantly raising rates until the business cycle turns down. Rising interest rates are the only cure to the current debt hangover, which will eventually encourage another painful deleveraging period. The fact that the riskiest rated junk bonds are outperforming investment grade this year clearly signals that investors are more worried about rate risks than default risks.

BCA Research points out that although households and the financial sector have significantly de-levered since the GFC, total debt has actually grown through a re-levering of government debt and nonfinancial corporate debt. Nearly US$4 Trillion of debt over the past decade has been used to finance dividends or buyback equity, which has unquestionably contributed to shareholder gains. Tighter monetary policy will, however, deflate the current credit bubble and remove a major tailwind to the stock market.

Source: BCA Research

S&P Global recently warned that the current credit cycle has peaked but acknowledged that default rates are not likely to accelerate until 2019. Abundant and cheap financing easily masks default levels because it prolongs the ability of weaker companies to survive and benefit from the extra time to recovery. Corporate profitability looks to have peaked and leverage has hit pre-crisis highs, both indicators of a late cycle point. There is a chorus of opposing views from credit managers, however, that believe the already long-running credit cycle has room to run.

They argue that the fundamental outlook for the economy is strong. In the U.S., real GDP growth is at 2.3% (annualized as of Q1-2018), business investment up 7.2%, real personal consumption is growth at 2.4%, and core durable goods orders rose 7.6% in March 2018, the best annual growth rate in four years. In Canada, consumer confidence is near cyclical highs and wage pressures are increasing. Based on output gap estimates of both the Bank of Canada and International Monetary Fund, there is essentially no spare capacity left in the Canadian economy[1].

Credit managers that expect several more years of expansion in the credit cycle point to commercial loan data to buttress their case. According to Credit Suisse, such data has been a reliable lead indicator for turning credit conditions, with banks historically tightening standards well before a turn in the cycle. The Fed’s latest Senior Loan Officer Opinion Survey shows banks are easing standards, a sign of improving credit conditions. Sixty percent of U.S. banks surveyed cited weaker loan demand in Q1-2018 due to aggressive competition from alternative lenders, which caused banks to loosen access to credit even further. Similarly, according to the Bank of Canada’s Spring 2018 Business Outlook Survey, most Canadian businesses consider credit as easy or relatively easy to obtain.

There seems to be no shortage of demand for credit, judging by the massive US$180 Billion raised for the private debt asset class last year. We see this as a contrarian signal and are not moved by biased credit managers eager to accumulate assets under management for the hottest alternative investment strategy in the world.[2]

The leveraged loan market in the U.S. has topped $1 Trillion according to S&P Global, that’s a doubling in the last 18 months. In predictable fashion, risk premiums have fallen to lowest levels since 2014.

According to S&P Global, a total of 62% of leveraged buyout loans in Q1-2018 had total leverage above 6X EBITDA, and an average of 6.4X for the total leveraged lending market .This can be explained in part by the relaxation of U.S. leveraged lending guidelines, which were introduced by the Fed, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation in 2013, and intended to prohibit banks from making loans when total leverage is above 4X. Borrower-friendly markets created by record levels of investor cash have not just caused leverage to rise (up from 5.9X in 2016) but investor protections to continue to weaken. When we last highlighted the low frequency of covenants in middle-market loans a year ago, we thought lender documentation could not worsen. We were wrong. Covenant quality has declined every month for the last twelve months and is at its weakest levels ever![3]

Bankers and private debt investors are justifying weaker documentation because of the factors described above, all of which are temporarily suppressing default rates. The latest survey of credit managers by S&P Global shows no expectations of rising defaults until at least 2020, a year longer than S&P Global’s own estimates. This benign outlook will encourage more risk-taking by lenders.

Credit managers have returned to the halcyon days when capital was ample, and risk was thought to be scarce. Members of our team, like Dev Bhangui, who was active in financing telecommunications companies in the 1990s, remember the influx of “concept companies” with no cash flows or assets that successfully raised billions in debt. These companies failed in huge numbers around the turn of the century. Similar companies are getting financed today, like WeWork, an office-sharing company described by the Financial Times as an “unprofitable company that does not own hard assets or offer a clear outlook for free cash flow”. On April 25, 2018, WeWork sold a 3X oversubscribed issue of $700 Million senior, unsecured bonds to investors at 7.875%. Alternative investors like Apollo might be partying, but we’re planning…for the coming wave of defaults.

[1] BCA Research

[2] Private Debt Investor, Q1-2018 fundraising data

[3] Moody’s Covenant Quality Indicator March 2018

Excerpted from Third Eye Capital Management Inc.’s Q1 2018 Investor Letter.