Morgan Stanley Turns Apocalyptic On Credit: "A Cycle Turn Is Closer Than Many Believe"

While many have repeatedly warned over the past year that the record gains in credit are simply too good to stay - especially in Europe where yields and spreads have collapsed largely thanks to the ECB"s relentless purchases of corporate debt, with the central bank announcing on Monday it held a record €127.7bn in bonds under its CSPP program - few are as bearish on credit as Morgan Stanley, which today issued ots 2018 US Credit Outlook which is, in a word, "dire."

In the report titled "When the Levee Breaks" strategist Adam Richmond list the three biggest headwinds for credit as follows: "Fed policy should become a material headwind, markets seem very late cycle, and valuations look extremely rich" and details each below:

An unprecedented central bank unwind... We think there is way too much complacency regarding what is a notable and growing shift in central bank policy globally. Remember, monetary policy has been massive in this cycle, and extremely supportive for credit markets. The Fed is now tightening in an untested way, through the balance sheet, while also pushing rates near restrictive territory. Markets expect a seamless unwind. We do not.

 

...with markets late cycle, and very dependent on ultra-easy liquidity... It is not a coincidence that fundamental problems are becoming more apparent in one sector after the next, as the Fed withdraws liquidity. In fact, we see late-cycle risks popping up all over the place, and as is often the case near a top, these risks are mistakenly (we think) being rationalized as purely "idiosyncratic" problems. Defaults should remain low in 2018, but that is expected. Credit markets anticipate defaults one year ahead of time, and we think a cycle turn is closer than many believe.

 

...and valuations very rich: Spreads are near all-time tights, adjusting for the quality deterioration in the indices over time. Yes, the technicals have been strong, but that may change as the Fed"s balance sheet shrinks faster. We note, a recession is not necessary to see negative excess returns, especially in the second half of a cycle, and particularly late in a Fed tightening cycle. Credit markets have not experienced three straight years of positive excess returns in over 20 years.

Looking at the technicals, Morgan Stanley echoes what we said last month when he showed the collapse in spreads to 2007 levels, and warns that "credit spreads are very rich nearly any way we slice the data. Spreads adjusted for leverage are back to 2007 levels in high yield, and 1997 levels in IG."

Exhibit 20 shows our fair value model for IG, HY and loans. In short, we estimate that IG, HY and loan spreads are 41bp, 197bp, and 111bp rich to fair value, respectively, using long-term default, downgrade, and risk-premium assumptions. And as we show in Exhibit 21 below, if we adjust for the deterioration in quality of the IG index over time, we find spreads are only 9bp wide of the all-time tights.

One of the main reasons for Richmond"s bearishness, is the "complacency" about the Fed"s tightening, which of course is applicable to all asset classes. He explains:

More than anything else, we firmly believe that central banks have been THE driver of credit in this cycle, stimulating markets like never before. Now they are attempting to tighten in a completely untested way, and yet credit is pricing in a seamless unwind. At the least, we expect a bumpier 2018, with a tougher setup anyway we slice it. Growth will decelerate, while the Fed continues tightening into a low-inflation environment, driving a completely flat yield curve (per our rates forecasts). Additionally, the year is beginning with booming confidence, as hopes for tax cuts rise, thus the bar to positively surprise is high, while "Goldilocks" is firmly in the price across most risk assets.

 

We would not rule out the scenario in which financial conditions could tighten materially next year as the Fed withdraws stimulus in this unprecedented way, especially if growth expectations decline at the same time, pushing us from late cycle to end of cycle (though not our economists’ base case). And for those expecting the Fed to come to the rescue any time volatility picks up, remember that, with the balance sheet now effectively set on "auto-pilot," reversing course, in our view, is a last resort.

 

Taking a step back, per our forecasts, the Fed will hike 3 times in 2018. While gradual on the surface, this rate-hike cycle needs to be put in context. In other words, as we show in Exhibit 3 this time around, the Fed began hiking much later in an expansion, when GDP growth was weaker and corporate leverage higher vs. the start of past rate-hike cycles. In fact, given the drop in the neutral real Fed funds rate over time, monetary policy is already not that far from restrictive territory

 

 

As a result, we believe markets can withstand less tightening than a low absolute level of rates might suggest (exhibit 4). And remember, this is a unique rate-hike cycle. One, tightening began not when the Fed first hiked rates in December 2015, but when they began tapering in early 2014. In this regard, the Fed has arguably already tightened policy by a similar amount as in past cycles (Exhibit 5), a point when credit spreads tend to widen on average (Exhibit 6). Two, along the same lines, the Fed is continuing to tighten, not just by hiking rates, but also through reverse QE.

 

 

In fact, we believe investors are focused primarily on the "gradual" pace of rate hikes, treating the balance sheet as an afterthought. But the numbers are large. For example, the Fed will shrink its balance sheet by ~$400bn in 2018 alone. In our view, credit investors underestimated the tailwind from QE in this bull market. Similarly, they may now be underestimating the headwind from reverse QE. And while global central banks will still be adding liquidity next year, even they will be doing so at a slower pace, with the ECB cutting their purchases in half in 2018 and likely ending QE altogether around September of next year, while the BOJ hikes their long-term rate target in 3Q18.

 

 

We see "quantitative tightening" as a clear catalyst for weaker technicals – i.e., fixed income demand needs to rise to absorb the additional supply or prices have to adjust somewhere (supply/demand 101). Why not expect the opposite of what happened when the Fed was expanding its balance sheet in this cycle (one-way flows into US credit), as the Fed begins its unwind, at least at the margin?

Assessing rate risk, MS says that while the Fed may in fact be successful at threading the needle, an outcome that is likely already priced into markets. However, the bank warns that "at the least we can be certain that as the balance sheet shrinks more rapidly, so will the "liquidity buffer" in markets, which should magnify any negative catalyst that pops up along the way."

Another major risk factor for Morgan Stanley is that the US economy is now very late in the cycle, to wit:

Markets are very late cycle, in our view, and if anything these risks have risen compared to this time last year. That we are in a late-cycle environment is a consensus view, but "late cycle" can mean different things to different people. To be more specific, we think there is a good chance that markets peak for the cycle in 1H18 and price in rising defaults in a bigger way throughout the year. But even if our timing continues to be too early, remember, late-cycle environments are often not great for credit returns regardless, with equities often outperforming. (Note, as we discuss further below, we believe the very late-cycle signal where credit/equities diverge is already happening, focusing on CCC-rated HY credit.) A recession is not necessary for credit spreads to widen late in a cycle. In fact, credit markets have not had three straight years of positive excess returns since 1996.

Here Richmond takes offense with the argument that weak growth for much of this cycle has prevented "excesses" from building, and hence an already long cycle can last even longer. As he says "we disagree and see excesses all over the place, driven in part by years of ultra-low rates." He notes the following specific details:

• Credit markets have grown by 116% in this cycle, and leverage is at unprecedented levels for a non-recessionary environment.


• Low quality BBB issuance was 44% of total IG supply in 2017, a record as far back as we have data, and B rated or below loan issuance is now two thirds of total loan supply.


• LBOs levered over 6x are now a higher percentage of new LBO loans than in 2007. Covenant quality is considerably weaker than pre-crisis, while the debt cushion beneath the average loan is much lower.


• Investors have reached for yield in fixed income in this cycle in a massive way. Foreign flows have flooded into the asset class, arguably treating US credit as a rates product, while liquidity needs have risen, with mutual fund/ETF ownership of credit now over 19% vs. 11% pre-crisis.


• Excesses are apparent even outside of corporate credit, with underwriting quality deteriorating in auto lending in this cycle, while non-mortgage consumer debt is at a high, and CRE prices are ~25% above prior-cycle peaks.


• Stock-buyback activity has been substantial in this cycle, credit valuations have rarely been richer, and consumer confidence has not been this high since 2000.

Summarizing, and "cutting through the details" Morgan Stanley says that it has high conviction in the following two points:

1. Excesses have to be out there, given what central banks have done in this cycle – i.e., rates near or below zero for nearly a decade and round after round of QE globally, and


2. the excesses are always difficult to spot as markets are rising, and then become obvious after the turn (how did I miss that?). We think this time is no different. To be clear, excesses are not everywhere. For example, credit quality did not deteriorate in places like housing and US financials in this cycle. However, this simply tells us that the problems of the last cycle will not be the same as the problems of the next.

As a result, 2018 is when the critical mass of excesses finally spills over, or, to reuse the title, "the levee finally breaks":

While the excesses may be out there, that has arguably been the case for a while. The difference, we think, is that more cracks are now forming under the surface, which in our view, means a turn is closer than the consensus believes. For example, outside of corporate credit, we have seen signs of weakness and tighter credit conditions in places like commercial real estate. Consumer delinquencies are rising across products (i.e., autos, credit cards, and student loans). And in corporate credit, one sector after the next is exhibiting "idiosyncratic" problems (e.g., Retail, Telecom, and Healthcare to name a few). All of this is consistent with a late-cycle environment where the yield curve is flattening, correlations in markets are dropping, the economy is at (or arguably through) full employment, the Fed is well advanced in its tightening cycle (we think), and equity multiples are expanding.

To Richmond, these dynamics are "late-cycle 101. Problems pop up early on in the areas that experienced the most severe deterioration in fundamentals in the bull market. Investors initially treat those issues as "idiosyncratic." The problems then spread when credit conditions tighten more broadly. And along these lines, we think it is not a coincidence that weaker-quality high yield credits are underperforming, as the Fed is hiking faster and quantitative tightening is now being set in motion."

If that wasn"t enough, Morgan Stanley highlights two further risks: one having to do with the incremental impact of tax cuts, should they pass...

And as a side note, tax cuts would not extend the cycle in our view – they risk doing the opposite. Very simply, credit markets will benefit from anything that keeps the cycle going – modest growth and a patient Fed. Tax cuts that come when the unemployment rate is 4.1%, which drives an overheating labor market, forcing a more aggressive Fed, if anything could cut off the cycle sooner.

... and the inevitable rise in default intensity:

We think there is a high likelihood that defaults will start rising again late next year and into 2019. Without going into the details here, in our view, CCC HY bonds are already "sniffing out" these budding default risks with their recent weakness. This should continue as tighter central bank policy exposes the fundamental challenges in the asset class (the problems are easier to hide when markets are flooded with liquidity). And the fundamental issues are broad-based. Not only is leverage high across sectors, but we also estimate that almost 30% of the HY market is either in secular decline or has clear operational challenges (Exhibit 16), with declining revenue growth over the past five years. Thinking about it more quantitatively, as we show in the default section below, based on the lag between when the cycle indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today, 2019 could be a year of materially higher defaults.

Wrapping up the above, Morgan Stanley"s conclusion is the following:

Adding everything up, we see three key challenges in 2018: 1) Credit markets have been hugely reliant on central banks in this cycle, and now the Fed is withdrawing liquidity in an unprecedented way. We think markets are underestimating the risks of a mistake. 2) This liquidity withdrawal is happening while late-cycle risks (we think) are popping up all over the place. 3) Investors are buying credit at valuations that almost guarantee poor long-term returns, with the assumption that they will be able to time when to get out before the turn.

... or stated even simpler, "get out now."

Meet The New Antibiotic-Resistant ‘Hypervirulent’ Superbug Discovered In China

Content originally published at iBankCoin.com

To take your mind off nuclear war with North Korea and deadly hurricanes, let’s talk about other ways to cull the herd…

Scientists at the Hong Kong Polytechnic University in Hangzhou, China have discovered a new strain of antibiotic-resistant pneumonia which spreads incredibly fast, after a 2016 outbreak in a hospital ICU led to the deaths of five patients ranging in age from 53 to 73. In findings published in The Lancet, researchers conclude that the new superbug poses a “substantial threat to human health” due to the fact that it is “simultaneously hypervirulent, multidrug resistant, and highly transmissible.”

K. pneumoniae  (ST11 CR-HvKP) is a triple threat; a deadly combination of two previously known strains of pneumonia; one which shrugs off all but the toughest antibiotics, and the other which is classified as ‘very severe’ and ‘hypervirulent’ in terms of lethality and how quickly it spreads.

The new report also reveals that samples from other parts of China tested positive for the new superbug, noting that “[f]ailure to control its early spread right now, will make a global epidemic of carbapenem-resistant [CRE], hypervirulent K. pneumoniae hard to avoid,” advising that “Control measures should be implemented to prevent further dissemination of such organisms.”

Epidimiologiests Liang Chen and Barry Kreisworth call the new strainof pneumoniae an “alarming evolutionary event.”

While Allergan’s FDA-approved antibiotic of last resort ‘Avibactam’ can likely handle ST11 CR-HvKP, it is not available in China, which leaves the country with nothing it its pharmaceutical arsenal to battle the infection.

Via NPR

The microbe can fight off all drugs available in China, Chen says. “We don’t have anything in China to stop it,” he says. “There is a drug available in the U.S. that should be effective against it, but we haven’t tested it yet.”

In the outbreak, the five patients who died were all older than 53. They were all on ventilators after undergoing major surgeries. And they died from severe lung failure, multiorgan failure or septic shock, the researchers found.

“The disease progresses very fast,” Chen says. “It starts in the lungs and then infects other organs, like the liver.”

Until China approves Avibactam or a similarly effective antibiotic of last resort, doctors and health officials can prevent the spread of hypervirulent pneumonia by quickly identifying outbreaks and isolating the infected.

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Record Apartment Building-Boom Meets Reality: First CRE Decline Since The Great Recession

By Wolf Richter of WolfStreet

Even the Fed put commercial real estate on its financial-stability worry list.

No, the crane counters were not wrong. In 2017, the ongoing apartment building-boom in the US will set a new record: 346,000 new rental apartments in buildings with 50+ units are expected to hit the market.

How superlative is this? Deliveries in 2017 will be 21% above the prior record set in 2016, based on data going back to 1997, by Yardi Matrix, via Rent Café. And even 2015 had set a record. Between 1997 and 2006, so pre-Financial-Crisis, annual completions averaged 212,740 units; 2017 will be 63% higher!

These numbers do not include condos, though many condos are purchased by investors and show up on the rental market. And they do not include apartments in buildings with fewer than 50 units. This chart shows just how phenomenal the building boom of large apartment developments has been over the past few years:

The largest metros are experiencing the largest additions to the rental stock. The chart below shows the number of rental apartments to be delivered in those metros in 2017. But caution in over-interpreting the chart – the population sizes of the metros differ enormously.

The New York City metro includes Northern New Jersey, Central New Jersey, and White Plains and is by far the largest metro in the US. So the nearly 27,000 apartments it is adding this year cannot be compared to the 5,400 apartments for San Francisco (near the bottom of the list). The city of San Francisco is small (about 1/10th the size of New York City itself), and is relatively small even when part of the Bay Area is included.

Other metros on this list are vast, such as the Dallas-Fort Worth metro which includes the surrounding cities such as Plano. Driving through the area on I-35 East gives you a feel for just how vast the metro is. However, I walk across San Francisco in less than two hours:

Special note: Chicago is adding 7,800 apartments even though the population has begun to shrink. So this isn’t necessarily going to work out.

This building boom of large apartment buildings is starting to have an impact on rents. In nearly all of the 12 most expensive rental markets, median asking rents have fallen from their peaks, and in several markets by the double digits, including Chicago (-19%!), Honolulu, San Francisco, and New York City.

And it has an impact on the prices of these buildings. Apartments are a big part of commercial real estate. They’re highly leveraged. Government Sponsored Enterprises such as Fanny Mae guarantee commercial mortgages on apartment buildings and package them in Commercial Mortgage-Backed Securities. So taxpayers are on the hook. Banks are on the hook too.

This is big business. And it is now doing something it hasn’t done since the Great Recession. The Commercial Property Price Index (CPPI) by Green Street, which tracks the “prices at which commercial real estate transactions are currently being negotiated and contracted,” plateaued briefly in December through February and then started to decline. By June, it was below where it had been in June 2016 – the first year-over-year decline since the Great Recession:

Some segments in the CPPI were up, notably industrial, which rose 9% year over year, benefiting from the shift to ecommerce, which entails a massive need for warehouses by Amazon [Is Amazon Eating UPS’s Lunch?] and other companies delivering goods to consumers.

But prices of mall properties fell 5%, prices of strip retail fell 4%, and prices of apartment buildings fell 3% year-over-year.

So for renters, there is some relief on the horizon, or already at hand – depending on the market. There’s nothing like an apartment glut to bring down rents. See what the oil glut in the US has done to the price of oil.

Investors in apartment buildings, lenders, and taxpayers (via Fannie Mae et al. that guarantee commercial mortgage-backed securities), however, face a treacherous road. Commercial real estate goes in cycles as the above chart shows. Those cycles are not benign. Plateaus don’t last long. And declines can be just as sharp, or sharper, than the surges, and the surges were breath-taking.

Even the Fed has put commercial real estate on its financial-stability worry list and has been tightening monetary policy in part to tamp down on the multi-year price surge. The Fed is worried about the banks, particularly the smaller banks that are heavily exposed to CRE loans and dropping collateral values.

But the new supply of apartment units hitting the market in 2018 and 2019 will even be larger. In Seattle, for example, there are 67,507 new apartment units in the pipeline.

Dead Mall Stalking: One Hedge Fund Manager’s Tour Across Middle-America – Part 2

Via AdventuresInCapitalism.com,

Continued from Part 1...

Malls are bearing the brunt of changes in retail, but they’re only the canary in the coal mine.

Let’s start with a simple premise; commercial real estate (CRE) will change more in the next decade than it has in the past hundred years. Anyone who thinks they can fully foresee how it will evolve is lying to you. The only certainty is that highly leveraged real estate investors and lenders will be obliterated as current models evolve faster than anticipated.

In the past, retail was retail, warehouse was warehouse and office was office—the same for all other CRE classes. There was some cross-over, but the main commercial real estate components stayed segmented for the most part. Now, with big box stores, the lowest hanging fruit for online shopping to knock off, going to dodo-land, there will be hundreds of millions of feet of well-located space suddenly becoming available. People act as if there are enough Ulta Beauty and Dick’s Sporting Goods to go around. However, you cannot fill all of this space with the few big box retail concepts still expanding—especially as many stalwarts are themselves shrinking.

As a result, a huge game of musical chairs is about to take place. Why pay $20/ft for mid-rise office space, if you can now move into an abandoned Sports Authority for $5/ft. Sure, it doesn’t come with windows, but employees like open plan space and there’s plenty of parking. Besides, with the rental savings, you can offer your staff an in-house fitness facility and cafeteria for free. Does your mega-church need a larger space? There’s probably a former Sears or Kmart that perfectly accommodates you at $3/ft. Have an assisted living facility with an expiring lease? Why not move it to an abandoned JC Penney—the geriatrics will feel right at home, as they’re the only ones still shopping there.  

Go onto any real estate website and you will find out that huge plan space is nearly free. No one knows what the hell to do with it and the waves of bankruptcy in big box are just starting. As online evolves, these waves will engulf other segments of retail as well.

Type Macy’s into Loopnet.com and look at how many millions of feet of old Macy’s are available for under $10/ft to purchase. Retail’s problems are about to become everyone’s problems in CRE. When the old Macy’s rents for $2/ft, what happens to everyone else’s rents? EXACTLY!!! What happens if a CRE owner is leveraged at 60% (currently considered conservative) and leasing at $15/ft when the old HHGregg across the street is offered for rent at $3/ft? An office owner can lower his rents a few dollars, but at the new price deck, he cannot cover his interest cost, much less his other operating expenses. What happens to a suddenly emptying mid-rise office building? It has higher operating expenses than the box store due to full-time security and cleaning—maybe it’s a zero—in that future market rents no longer cover the operating expenses of the asset, much less offer a return on investment. I know, crazy—that’s how musical chairs works when demand contracts and the supply stays the same.

What happens to the guys who lent against these assets? Kaplooey!!!

America currently has more feet of retail space per capita than any other country. For that matter, America has more feet of office and other CRE types per capita as well. A decade of low interest rates has made this problem substantially worse. Think of the two malls that I spoke about in the last piece—they weren’t done in by the internet, they were done in by a tripling of retail space in a cities that are barely growing. These cities simply ran out of shoppers for all of this space. Now the mall is empty—heck the strip retail is only partly filled in. The next step is that rents will drop—dramatically. The owners of each asset, the mall and the strip center will go bust. Neither has a cap structure that is designed for dramatically lower rents. Neither has an org structure designed for carving up this space for the sorts of eclectic tenants that will eventually absorb it over the next few decades.

CRE has had it so good for the past 35 years, that most owners have never seen a down cycle. Sure, Dallas had too much supply in the early ‘90’s. Silicon Valley over-expanded in the early ‘00’s. It took a few years for it to be absorbed. Anyone who had capital during the bust made a fortune. This time may really be different. There’s too much supply. Short of blowing it up, it will be with us for years into the future. Without dramatic economic or population growth, some of it may NEVER be absorbed.

As an investor, this is all interesting to understand, but you don’t fully comprehend it until you have visited a few dozen of these facilities and seen how owners are trying to cope with the problem. In Miami, space is constricted. In Texas, there’s more CRE than I’ve ever seen. They keep putting it up—even if there isn’t demand currently. For three decades, they’ve always been able to fill it over time. For the first time ever, they can’t seem to fill it—in fact, demand is now declining. It is now obvious; there will be a whole lot of pain for CRE owners and lenders. Of course, someone’s pain can be someone’s gain.

To be continued…

$200 Billion Asset Manager Warns "There's Danger At The Door" As Markets Lose Focus On Fundamentals

There was a time "when central banking was an honest profession," remarks TCW Group"s fixed income CIO Ted Rivelle, warning that "asset prices are not meant to be arbitrary quantities that are to be steered or targeted by central bankers."

In his latest letter to investors, Rivelle, whose firm overseas $195 billion in assets details The Fed"s quixotic journey to kill the business cycle.. and in fact any other cycle except higher asset prices. However, As Rivelle warns,

"The signs of late cycle excess continue to spread, but faith abides in central banking “stimulus”. We all do well to remember that when markets lose focus on the fundamentals, there is danger at the door."

The global financial crisis is so nine years ago, and still the central banks can’t seem to find a way to “normalize” policy. Measures that had been introduced as emergency responses have morphed into permanent fixtures without which, we are told, growth would become impossible. And, so, not only do the balance sheets of the world’s central banks continue their relentless expansion, the rate of expansion has actually accelerated to a rate of $2 trillion per year, i.e., more than the GDP of Italy (see following exhibit). Since the 2008 meltdown, the technocrats have “minted” a collective $10 trillion worth of new balance sheet in a failed attempt to achieve “escape velocity.” Yet, what these extraordinary measures have failed to achieve in terms of wages and incomes, they have more than “made up” for in terms of leverage and asset prices.

The global capital markets have proven adept at transmitting newly created credit from one region to the next and from this asset class to that. Hence, the central banking “stimulus” programs have had a deep and very widespread scope of impact. Rates are set negative here, driving a reach for yield there. Corporate debt removed from circulation in Europe supports narrow risk premia in the U.S. But, to what end? Without a sustainable rise in GDP and incomes to match this global levitation in asset prices and leverage, the central bankers are only ensuring that when the inevitable cycle denouement comes, the down trade will be omnipresent.

Central Banks Are Adding Stimulus At The Highest Rate For This Cycle

Source: National Central Banks, Bloomberg, TCW.
*ECB injections include gross LTRO and TLTRO balances.

All the while, the Fed doth protest that it will surely “normalize” rates over time, yet never seems to find just the right combination of unemployment, inflation, and asset prices that would justify a credible march towards “normalization.” The reason for this is as simple as it is portentous: after having acclimated the global economy to an artificially low rate and risk premia environment, “normalization” is no longer possible without a severe retrenchment in asset prices.

So, if the Fed can just hold off raising rates and the rest of the central banks keep stimulating, is the risk-on trade safe indefinitely? That does seem to be the consensus logic. Yet, alas, if this cycle doesn’t end badly, it will be the first one in the history of financial capitalism that hasn’t. Cycles don’t just live on because central banks can temporarily evade the market’s self-correcting impulses, just as breaking the thermometer doesn’t cool the oven. This cycle’s grand experiment in centralized rate suppression has taught investors to “just look the other way” rather than attending to those late cycle signs that warn of impending risk.

If you are willing, we’ll have you look at just these six signs:

1. Low rates have incentivized managements to “arbitrage” their earnings yield against the low cost of the borrow through such re-leveraging activities as share repurchases. As a result, corporate leverage has grown, even as profit growth has sputtered. The median U.S. investment grade company now sports three units of (gross) debt per unit of EBITDA, a level that traditionally has strained the very definition of what constitutes investment grade.

Source: JP Morgan, TCW
*Weighted by amount of debt outstanding.

2. High yield bonds provide thin compensation against the risk of default. Imputing a historically low annual loss adjustment assumption, the median high yield bond provides only marginal yield premium relative to a BBB investment grade bond. We don’t see the value in extending multiple turns of leverage for an extra 20 bps of yield.

Source: Barclays, TCW
*As of May 23, 2017

3. The bellwether auto industry has passed its cyclical peak. Auto sales are falling from their plateau even in the face of a cycle peak in manufacturers’ incentive payments that now foot to over 10% of the typical new car purchase price. Meanwhile, the used car market demonstrates signs of “saturation,” eating away at the pricing power of the seller in both the new and used car markets.

U.S. Car Sales Have Been Artificially Supported By Manufacturers’ Incentives

Source: Bloomberg, TrueCar, TCW

Used Car Values Have Fallen Precipitously

Source: J.D. Power Valuation Services

4. Retail employs more people in the U.S. than does manufacturing, accounting for some 11% of the workforce. Unless you live in a cave, you know that both restructuring and distress are coming to a store near you. The number of retail outlets expected to close in 2017 will exceed that of 2008. Meanwhile, as retail comprises some 30% of the commercial real-estate (CRE) market, don’t expect CRE valuations to survive unscathed.

Retail Store Closings

* Estimated based on actual YTD closings through April 2017 and historical annual closing trends.
Source: Credit Suisse, TCW

A Falling Price for the 2012 Vintage CRE Debt Index Reflects Expectations for Rising Losses

Source: Markit, TCW

5. 10 largest banks: then and now. Laying claim to having the biggest banks might seem to be a source of national pride. It isn’t. Your banking system gets to be the biggest by originating more loans than “everyone” else. At the height of the Japanese equity/real-estate bubble, its banks towered over the competition. Today, four of the five largest banks in the world are the Chinese state banks. History doesn’t repeat, but perhaps it rhymes.

10 Largest Banks: 1987*

Source: LA Times, American Banker
*Largest 10 banks in the world by deposits

10 Largest Banks: 2016**

Source: Statista
**Largest 10 banks in the world by assests

6. Spreads on Emerging Market sovereign and quasi-sovereign debt have remediated to mid-2013 levels, despite the fact that the percent of below investment grade bonds in this universe approaches 50%, a level nearly double of what it was in 2013.

Source: JP Morgan, TCW

Conclusion

Times were when central banking was an honest profession. Asset prices are not meant to be arbitrary quantities that are to be steered or targeted by central bankers. The signs of late cycle excess continue to spread, but faith abides in central banking “stimulus”. We all do well to remember that when markets lose focus on the fundamentals, there is danger at the door.

We Now Know "Who Hit The Brakes" As Loan Creation Crashes To Six Year Low

The wheels are falling off the US bank loan market.

After we first showed in early March the steep drop in bank loan creation for both Commercial and Industrial, auto and total loans - all traditionally leading indicators to economic contraction and recession as business and consumers halt spending, even with borrowed money - numerous other analysts and pundits have attempted to explain, and justify why one should not be particularly concerned about this tumbling indicator. Most notable among them Goldman, who in late March "explained" that there was nothing ominous about the crash in loan creation, and instead it was just a function of a base effect, and a shift from loan to corporate bond issuance.

Two months later we can confirm that not only was Goldman wrong, but so are all the Pollyannas who assert there is nothing troubling about the ongoing collapse in loan creation.

According to the latest Fed data, the all-important C&I loan growth contraction has not only continued, but over the past two months, another 50% has been chopped off, and what in early March was a 4.0% annual growth is now barely positive, down to just 2.0%, and set to turn negative in just a few weeks. This was the lowest growth rate since May 2011, right around the time the Fed was about to launch QE2.

At the same time, total loan growth has likewise continued to decline, and as of the second week of May was down to 3.8%, the weakest overall loan creation in three years.

Another loan category that has seen a dramatic slowdown since last September, when Ford"s CEO aptly predicted that "sales have reached a plateau."  Since then auto loan growth has been slashed by more than 50% and at this runrate, is set to turn negative some time in late 2017.  Needless to say, that would wreak even further havoc on the US car market.

For a while, despite numerous attempts at explanation, there was no definitive theory why this dramatic slowdown was taking place. It even prompted the WSJ to inquire "who hit the brakes?"

Well, after the latest Fed Senior Loan Officer Survey, we may have the answer.

First, recall that in late April we showed another very troubling trend: consumer credit card default rate as tracked by S&P/Experian Bankcard had surged to the highest level since June 2013, suggesting that contrary to reports otherwise, the US consumer is increasingly unwell.

A quick look at the latest Fed Senior Loan officer survey revealed even more disturbing trends. According to the report, "banks reported tightening most credit policies on Commercial Real Estate loans over the past year.... On balance, banks reported weaker demand for CRE loans in the first quarter." Even more troubling was the continued drop in demand for C&I loans among small, medium and large corporations, with "inquiries for C&I lines of credit remained basically unchanged" staying at a modestly depressed rate.

This stark admission that in addition to declining bank supply due to tighter standard (i.e., worries about further losses), there was less demand by businesses and consumers for loans, has explained once and for all the ongoing collapse in commercial bank loan creation, both total, C&I and auto. Of the two, the declining demand for loans businesses, is by far the most concerning aspect of an economy that is supposedly growing, and where companies should be willing to take out new credit to fund expansion (instead of merely issuing bonds to buyback their stock).

Digging deeper into the Fed report confirmed the worst-case scenario: the collapse in loan growth was almost entirely due to a sharp, recent consumer revulsion toward credit, with reduced level of consumer card and auto loan demand in the quarter. The decline took place despite "visibly softer" underwriting standards for cards which surprised some analysts as not creating incremental demand;

And while C&I loans are tumbling, demand for credit cards is now running at the lowest level in the 5 years the survey has provided credit- card-only data for consumer demand.

With all that, we can now close the book on the WSJ"s previously unanswered question of "who hit the breaks?" The answer: the US consumer, the driver behind 70% of US GDP, officially tapped out.

In fact, it was almost as if US consumers were hit by a perfect storm of adverse events in late 2016 and early 2017, just as GDP was on the verge of its first pre-recessionary contraction in years, and just as the S&P rose to new all time highs to distract from what is emerging as an imminent US recession.

Here"s the bottom line: unless there is a sharp rebound in loan growth in the next 3-6 months - whether due to greater demand or easier supply - this most accurate of leading economic indicators guarantees that a recession is now inevitable. How accurate: every single time C&I loan peaked, a US recession follow. We doubt this time will be different.

Fed Reports Unexpected Collapse In Credit Card, Auto Loan Demand

Two weeks after we reported that the consumer credit card default rate as tracked by S&P/Experian Bankcard had surged to the highest level since June 2013...

... we were looking forward to the latest Fed Senior Loan officer survey for more details about changing loan dynamics within US society.

What the report revealed was troubling: while on the surface, the Loan Officer Survey characterized loans to businesses as "basically unchanged" from the previous survey, it did remark that standards for commercial real estate (CRE) loans had tightened.

According to the report, "banks reported tightening most credit policies on Commercial Real Estate loans over the past year.... On balance, banks reported weaker demand for CRE loans in the first quarter."

More concering was the continued drop in demand for C&I loans among small, medium and large corporations, with "inquiries for C&I lines of credit remained basically unchanged" staying at a modestly depressed rate.

This helps explain, once and for all, the recent collapse in Y/Y commercial bank loan creation, both total and C&I, and indicated that contrary to Goldman"s take, the steep drop has nothing to do with calendarization or a base effect, and everything to do with declining demand for the product among America"s businesses, a concerning deterioration in an economy that is reportedly improving, and where companies would be willing to take out new credit to fund expansion.

Digging deeper revealed an even more distressing picture as a result of a sharp consumer revulsion toward credit, with reduced level of consumer card and auto loan demand in the quarter. The decline took place despite "visibly softer" underwriting standards for cards which surprised some analysts as not creating incremental demand;

Worse, demand for credit cards is now running at the lowest level in the 5 years the survey has provided credit- card-only data for consumer demand.

The report included special questions regarding commercial real estate lending conditions. Tighter credit policies for most CRE loans were the result of "a less favorable or more uncertain outlook for CRE property prices, vacancy rates or other fundamentals on CRE properties, and capitalization rates, as well as reduced tolerance for risk. Significant net shares of banks also reported less aggressive competition from other banks or nonbank financial institutions and increased concerns about the effects of regulatory changes or supervisory actions as important reasons for tightening CRE credit policies." (Emphasis added.)

Additionally, lending for residential real estate reflected little change in standards or demand by consumers. There was also little change to standards or demand for home equity lines of credit. Auto lending standards tightened. It is likely that concerns about the quality of auto loans may be driving some of the more restrictive conditions for lending. For credit card loans, there was some easing of standards and terms were "basically unchanged".

According to Stone McCarthy the contraction in the retail sector has had some impact here as several chains have significantly reduced or eliminated their brick-and-motor presence.

Not surprisingly, as demand for credit bumbled, banks" willingness to lend improved to 10.8 in April after slipping to 3.1 in January.

Finally here are excerpts from several sellside reports, all of which we unpleasantly surprised by the report, courtesy of Bloomberg.

WELLS FARGO (Matthew Burnell) 

• Primary takeaway remains reduced level of consumer card, auto demand vs 3Q after visible drop in 1Q (published in Jan., responses provided in Dec.)


• Notes "visibly softer" underwriting standards for cards aren’t creating demand; demand now running at lowest level in the 5 years the survey has provided credit- card-only data for consumer demand


• Standards across most other loan products were largely stable, though demand for commercial loan and commercial real estate dropped slightly from prior survey and mortgage demand ticked slightly higher (thanks to lower mortgage rates)

JPMORGAN (Daniel Silver)

• Survey was "a mixed bag," with weakening demand for many key series but also easing in lending standards for some major lending categories


• Easing C&I lending standards may be most important takeaway, even as demand declined

BARCLAYS (Jason Goldberg)

• Loan demand across all lending segments generally softened during 1Q, with C&I demand modestly weaker (though inquiries for C&I lines of credit was unchanged); CRE (broad-based), credit card, auto also weaker


• Key reasons included decreases in customers’ investment in plant or equipment and decreases in M&A financing needs


• Tighter lending standards could foreshadow CRE (particularly C&D and multifamily), auto credit quality deterioration; regulators still focused on CRE


• Lists banks most exposed to auto loans: ALLY followed by COF, HBAN, CFG, FITB, while COF, C, JPM, BAC have largest credit card concentration (all >10% of loans); JPM, MTB, COF, KEY have largest multi- family exposure (though all

EVERCORE ISI (John Pancari)

• Survey shows "tempered tone" around growth, largely reinforcing themes observed in recent results, including sluggish demand and credit tightening


• Notes little change in level of inquiries for C&I lines contrasts with 1Q bank mgmt comments mentioning pickup in borrower optimism, new line openings

SUSQUEHANNA (Jack Micenko)

• Trends support Susquehanna’s neutral view of regional banks (BBT, CMA, FITB, HBAN, KEY, PNC, RF, STI, USB, WFC, ZION) as optimism has yet to translate into notable improvement in loan demand

Superbugs may be More Widespread than Previously Thought

The potentially deadly, drug-resistant “superbug,” carbapenem-resistant Enterobacteriaceae (CRE), is more widespread in U.S. hospitals than previously thought, an earlier-released study has found. [1]

Researchers looked for cases of infections caused by CRE in a sample of 4 U.S. hospitals – 3 in the Boston area and 1 in California – and identified numerous varieties of the bacterium. [2]

Each year, CRE bacteria sicken about 9,300 people and claim the lives of 600 people in the United States, according to the CDC. Those numbers are climbing. CRE bacteria, in particular, have been called “nightmare bacteria” by CDC Director Tom Frieden because they often continue to thrive even in the face of “last-resort” antibiotics – drugs reserved for the toughest infections. [1]

Read: It’s Here – Bacteria Resistant to ALL Antibiotics Shows up in the U.S.

In the study, the researchers also found that CRE has a plethora of genetic traits that make it resistant to antibiotics, and these traits can be easily transferred between the many CRE species.

The study documented the identical gene in different species. William Hanage, associate professor of epidemiology at Harvard Chan School and senior author of the study, says that “the extent to which this has happened is really quite surprising,” He added that the team “found 2 cases of high-level resistance we could not explain.”

He compared it to dark matter: 

“We know it’s there because we can see its effects, but what’s actually making it happen at the moment is unknown. If I were to criticize my own work, I would say it is a shame that we weren’t able to get more hospitals and more samples from elsewhere within the health care systems.”

Based on the findings, the researchers believe that CRE is more common than previously thought, and that it may be transmitted from person to person without causing symptoms.

Source: CBC News

In fact, Dr. Alex Kallen, a medical officer in the CDC’s Division of Healthcare Quality Promotion, said “the most common source of transmission with CRE is asymptomatic.” For that reason, the team writes in Proceedings of the National Academy of Sciences, there needs to be increased surveillance of CRE. [2]

A healthy person might be able to carry CRE (it resides in the gastrointestinal tract) without developing an infection. However, if the bacterium is transferred to someone with a compromised immune system, it can be deadly. [1] [2]

Hanage said:

“We often talk about the rising tide of antibiotic resistance in apocalyptic terms. But we should always remember that the people who are most at risk of these things would be at risk for any infection, because they are often among the frailer people in the health care system. [2]

While the typical focus has been on treating sick patients with CRE-related infections, our new findings suggest that CRE is spreading beyond the obvious cases of disease. We need to look harder for this unobserved transmission within our communities and health care facilities if we want to stamp it out. [1]

The best way to stop CRE making people sick is to prevent transmission in the first place. If it is right that we are missing a lot of transmission, then only focusing on cases of disease is like playing whack-a-mole; we can be sure the bacteria will pop up again somewhere else.”

On a related front, it has come to light that a Nevada woman in her 70’s died months ago from a CRE infection that none of the 26 antibiotics available in the United States would touch. Dr. James Johnson, a professor of infectious diseases at the University of Minnesota, said of the case:

“I think this is the harbinger of future badness to come.” [3]

Read: Antimicrobial Resistance Could be a “Bigger Threat Than Cancer by 2050”

Johnson added that it’s hard to believe nobody else in the country is carrying the same strain. He said that when people ask him “How close are we to the edge of the cliff?,” he tells them: “We’re already falling off the cliff.”

Last fall, a Reuters investigation revealed that thousands of U.S. deaths due to superbugs go unreported each year, because in many cases it is not indicated on death certificates.

Source:

[1] HealthDay

[2] CNN

[3] USA Today

CBC News

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About Mike Barrett:
	Mike is the co-founder, editor, and researcher behind Natural Society. Studying the work of top natural health activists, and writing special reports for top 10 alternative health websites, Mike has written hundreds of articles and pages on how to obtain optimum wellness through natural health.

Are Markets Overlooking A Clear & Present Danger?

Authored by Lance Roberts via Real Investment Advice,

There is in interesting dichotomy currently occurring within the economy. While consumer confidence, as reported by the Census Bureau, soared to some of the highest levels seen since the turn of the century, the hard economic data continues to remain quite weak. As noted by Morgan Stanley just recently:

“Compare the New York Federal Reserve Bank’s current 1Q GDP tracking vs ours – FRBNY is currently tracking 1Q GDP at 3.0% versus us around 1%. The difference is larger than usual and is being driven by the fact that the New York Fed incorporates soft data into its tracking (attempting to tie it econometrically to GDP, a very hard thing to do especially in real-time). Our method translates the incoming hard data into its GDP equivalent. Note that the Atlanta Fed’s GDPNow tracking also focuses on hard data and is currently tracking 1% for 1Q GDP.”

The stunning divergence can be seen in the chart attached to that same article which shows the difference between the “hard” and “soft” data specifically.

What is currently expected by those with a more “bullish bias” is the hard data will soon play catch up with the soft data. Importantly, as I discussed in “Fade To Black”, this is the basis of the markets continued optimism that tax reforms, repatriations and infrastructure spending create the “reflationary” dynamics necessary to spur economic growth of 3-4%.

However, there may be a problem.

Economic cycles do not last indefinitely. While fiscal and monetary policies can extend cycles by “pulling forward” future consumption, such actions create an eventual “void” that cannot be filled. In fact, there is mounting evidence the “event horizon” may have been reached as seen through the lens of auto sales.

Following the financial crisis the average age of vehicles on the road had gotten fairly extended so a replacement cycle became more likely. This replacement cycle was accelerated when the Obama Administration launched the “cash for clunkers” program which reduced the number of “used” vehicles for sale pushing individuals into new cars. Combine replacement needs with low interest rates, easy financing, and extended terms and you get a sales cycle as shown below.

The issue is, of course, there are only a finite number of people to sell new cars too.

What the chart above shows is the number of cars sold currently now exceeds both the total increase in population and replacement needs of the existing population. In other words, the pool of available buyers is rapidly being depleted.

But more importantly, while the media touts “record auto sales,” it is a far different story when compared to the increase in the population. With total sales only slightly eclipsing the previous record, given the increase in the population this is not the victory the media wishes to make it sound. In fact, the current level of auto sales on a per capita basis is only back to where near the bottom of recessions with the exception of the “financial crisis.”

Furthermore, the annual rate of auto sales has slowed dramatically and is approaching levels normally associated with more severe economic weakness.

But slowing auto sales is only one-half of the problem. The problem for automakers is, as always, they continue to produce inventory even though demand is slowing. The cars are then shifted to dealers which have to resort to increasing levels of incentives to get the inventory sold. However, eventually, this is a losing game. The chart below shows the current level of swelling inventories relative to sales.

There is a limit to the level of incentives that dealers can provide to move inventory. Wolf Richter recently penned a really good report on this issue:

“J.D. Power and LMC Automotive pegged incentives at $3,768 per new vehicle sold – the highest ever for any March. The prior record for March was achieved in 2009 as the industry was collapsing. In June 2009, GM filed for bankruptcy.”

The Subprime Problem Resurfaces

Given the lack of wage growth, consumers are needing to get payments down to levels where they can afford them. Furthermore, about 1/3rd of the loans are going to individuals with credit scores averaging 550 which carry much higher rates up to 20%. In fact, since 2010, the share of sub-prime Auto ABS origination has come from deep subprime deals which have increased from just 5.1% in 2010 to 32.5% currently. That growth has been augmented by the emergence of new deep sub-prime lenders which are lenders who did not issue loans prior to 2012.

While there has been much touting of the strength of the consumer in recent years, it has been a credit driven mirage. With income growth weak, debt levels elevated and rent and health care costs chipping away at disposable incomes, in order to make payments even remotely possible, terms are often stretched to 84 months.

The eventual issue is that since cars are typically turned over every 3-5 years on average, borrowers are typically upside down in their vehicle when it comes time to trade it in. Between the negative equity of their trade-in, along with title, taxes, and license fees, and a hefty dealer profit rolled into the original loan, there is going to be a substantial problem down the road. As noted by Reuters:

“Typically, car dealers tack on an amount equal to the negative equity to a loan for the consumers’ next vehicle. To keep the monthly payments stable, the new credit is for a greater length of time.

Over the course of multiple trade-ins, negative equity accumulates. Moody’s calls this the ‘trade-in treadmill,’ the result of which is ‘increasing lender risk, with larger and larger loss-severity exposure.’

To ease consumers’ monthly payments, auto manufacturers could subsidize lenders or increase incentives to reduce purchase prices, though either action would reduce their profits, the report said.”

Auto loans, in general, have been in a huge boom that reached $1.11 trillion in the fourth quarter 2016. As noted above, 33.5% of those loans are sub-prime, or $371.85 billion.

With more sub-prime auto loans outstanding currently than prior to the financial crisis, defaults rising rapidly and a large majority with negative equity in their vehicles, swapping out to a new car is becoming a near impossible option. Recently, Matt Turner cobbled together some interesting data from several sources on this issue.

The 60-day delinquency rate for subprime auto loans is at the highest level in at least seven years according to Fitch. The jump in losses on sub-prime auto loans moved to 9.1% in January, up from 7.9% a year earlier. The data suggests there is notable deterioration in the performance of these loans and given there are roughly 6-million individuals at least 90-days late on payments suggests rising stress levels of the consumer.

While the “cash for clunkers” program by the Obama Administration caused a massive surge in used vehicle prices due to the rapid depletion of inventory at the time, much of that inventory has now been rebuilt. Now, used vehicle prices are dropping sharply, as the market is flooded with off-lease vehicles and consumer demand is weakening.

As noted above, the issue of the “trade-in treadmill” is a major issue for auto lenders as default risk continues to increase. Per Moody’s:

“The percentage of trade-ins with negative equity is at an all-time high, as is the average dollar amount of that negative equity. Lenders are increasingly faced with the choice of taking on greater risk by rolling negative equity at trade-in into the next vehicle loan. We believe they are increasingly taking this choice, resulting in mounting negative equity with successive new-car purchases.”

Asset-backed securities based on auto loans are showing signs of stress, with the subprime auto ABS delinquency rate closing in on crisis-era peak levels. Per Morgan Stanley:

“Across prime and subprime ABS, 60+ delinquencies are currently printing at 0.54% and 4.51%, respectively, with the latter approaching crisis-era peak levels (4.69%). Default rates are also picking up in similar fashion (prime: 1.52%; subprime: 11.96%), printing close to crisis levels. While prime severities slowly crept past 50% recently, subprime severities have breached 60%, a level we haven’t seen since late 2009. With both default rates and loss severities trending up, it is no surprise to see annualized net loss rates moving in the same direction.”

Given the importance of automobiles to the domestic manufacturing sector of the economy, the extent to which the sale of autos to consumers has likely reached an important inflection point. As shown in the last chart below, the previous recessionary warnings from autos was dismissed until far too late, it is likely not a good idea to dismiss it this time.

Why does this matter? Because it isn’t just auto loans. As Edward Harrison at Credit Writedowns noted:

“The big three areas of credit expansion this cycle – energy, auto and student loans.”

In the fall 2016 survey ahead of the latest borrowing reassessment this past October, Haynes and Boone said that respondents on average expected 41 percent of the borrowers to see a decrease. This decrease was expected at an average of 20 percent, in which lenders were expecting a 16-percent decrease and borrowers a 29-percent decrease.

While energy prices recovered enough to allow drillers to start back operations, primarily in the Permian Basin, the surge in supply is leading to another potential glut by 2018 and another downturn in oil prices. Such an event will put further strain on lenders as default risk rise in the sector. 

Currently, 42.4 million Americans owe $1.3 trillion in federal student loans. More than 4.2 million borrowers were in default as of the end of 2016, up from 3.6 million in 2015. In all, 1.1 million more borrowers went into or re-entered default last year.

And then there is also the problem of commercial real estate (CRE) where rapid loan growth over the past year, combined with recent underwriting reviews, raise many concerns over the quality of CRE risk management, particularly managing concentrations. Add to that weak underwriting and erosion of covenant protections in leveraged lending and you have real problems.

So, if you are wondering where the next “economic shock” may come from...there is a “clear and present danger” lurking below the headlines.