By Justin Pawl, CFA, CAIA
Inside this week’s edition:
- Shipping Sinks. Declining cargo volume at two U.S. ports reflect impact of trade war.
- Credit Cracks. Recent losses in the CLO market bay be a harbinger for high yield investments.
- Bright Note. Global growth bottoming?
Last Week Today. Domestic economic data releases skewed weak. | The headline October retail sales report showed a month-over-month rise of +0.3% (vs. +0.2% consensus), but keep in mind the bar was low as retail sales in September were down -0.3%, and ex-Autos, retail sales for October only rose +0.2% (vs. +0.4% consensus). | The Producer Price Index (PPI) was weak across the board for October. The PPI is known as the “inflation pipeline” because it represents prices paid by wholesalers and manufacturers further up the value chain from the end consumer. We remain firmly in the camp that dis-inflation, not inflation, is what the Fed should be focused on and monetary policy remains too tight. | Speaking of which, the Atlanta Fed’s GDPNow forecast for Q4 annualized real growth in the economy plummeted from +1.0% to +0.3%.
Financial Markets. U.S. and international equities rose for the sixth consecutive week. Here at home, the Dow and S&P 500 each rose about 1% for the week, breaking through round number levels (28,000 and 3,100, respectively) and recording new highs. The Nasdaq rose +0.8% to a new high as well. Developed international stocks barely kept their winning streak alive, rising a modest +0.1%, while emerging market equities slipped -1.5% dragged down by China’s -3.3% decline. Bond yields reversed their sharp upward move of the last few weeks, as the yield on the 10yr Treasury bond declined -0.11% to 1.83%. The commodity complex was mixed, but generally positive led by precious metals (Gold +0.6%, Silver +0.9%) and WTI Crude, which after last week’s gain of +0.8% is now +6.5% MTD at $57.72 per barrel. For more detail on weekly, MTD, and YTD financial market performance, click on the table below.
Shipping Sinks. At the two busiest entry points for Pacific trade, imports at the Los Angeles and Long Beach ports dropped 14.1% from a year ago. Activity at these ports are a good indication of how the US/China trade war is impacting global commerce. The Wall Street Journal suggested the decline in imports is related to inventory stocking that took place in advance of the tariffs that were enacted in September. Yet, others are not so sure as some of the business may have been permanently transferred to domestic producers. Resolution of the trade war would provide the answer, but for now it remains an unknown.
The chart below illustrates a few data series, but focus on the blue line. Note the steep year-over-year decline in the number of California Mega-Port Inbound Containers which is now at a level last seen when the global economy was finding its feet following the Financial Crisis.
Credit Cracks. Losses in the high yielding, but riskier segments of the Collateralized Loan Obligation (CLO) market are sending a cautionary signal for those reaching for yield.
CLOs are a fast-growing segment of the credit markets, dominated by institutional investors, but poorly understood by the general public. A CLO is a single security backed (or “collateralized”) by a pool of debt. Often the collateral consists of corporate loans with low credit ratings. The manager of a CLO sells stakes in the CLO called “tranches” of debt and equity to fund the loan purchases. Interest and principal payments by the corporations on the loans is then used to pay back the investors in the CLO according to the priority of the CLO tranches. As illustrated in the chart below, debt tranches that are more senior in the CLO (e.g., AAA and AA) receive payment priority. But, due to their payment priority, they are considered less risky, and investors in these tranches are paid a lower interest rate than the riskier BB and B tranches that are more likely to be impacted by loan defaults.
Yes, CLOs resemble the mortgage-backed securities (MBS) that imploded during the Financial Crisis and that Warren Buffet called “financial weapons of mass destruction.” For those that don’t remember, MBS were bundles of subprime mortgages that credit agencies rated as investment grade debt, but later brought the global financial system to its knees when housing prices fell. While CLOs resemble MBS, CLOs are actually more stable, and even during the Financial Crisis very few defaulted. That’s not to say they’re not risky, as CLO prices declined precipitously during the Financial Crisis and those that sold their positions sustained significant losses. The relative stability of CLOs and the high interest rates paid on the riskier debt tranches (some of which are around 10% per year) has fueled interest from government pensions, hedge funds, and other yield-hungry investors. Indeed, the CLO market has doubled in the last three years to $680 billion on the back of institutional investor demand.
However, last week the Wall Street Journal published an article about how some of the riskier CLO securities have given back nearly all their year-to-date gains in the last few months. Companies are running out of cash to pay back their loans, cutting off the cashflow used to make interest payments on CLO bonds.
This situation is important to monitor because CLOs play a critical role in acquiring loans issued by low credit quality companies. According to the article, CLOs bought more than 60% of newly issued loans from these companies in the last few years. If investor demand for CLOs wanes, then CLOs will have less capital to purchase loans, which in turn will drive up financing costs for companies issuing low credit quality debt.
CLO performance also has implications for investors in high yield debt. Many of the same companies that issue leveraged loans purchased by CLOs, also issue high yield debt (note that the loans purchased by CLOs are generally secured by assets of the company and senior in the capital structure to high yield debt, which is generally unsecured). Though high yield bonds continue to perform well this year, continued weakness in CLO performance may serve as a warning about the ability of these companies to meet the interest and principal payment requirements on the high yield debt they’ve sold to the market.
Thus far the issues in CLO-land have yet to spill over into the broader market, but this is worth keeping on your radar. Leveraged loans and high yield debt are higher in the corporate capital structure than equity (i.e., publicly traded stock) and if investors come to believe that companies cannot pay their debts, stock prices of these indebted companies will suffer.
Bright Note. Recognizing that much of this week’s missive highlights troubling signals, I wanted to better balance the blog and end on a bright note, or at least a potentially positive sign. In the chart below, the dark gray line is a six-month forward indicator of the global business cycle developed by Capital Economics, a well-known economic research firm. Capital Economics, combines data from the Organisation for Economic Co-operation and Development with its own proprietary data to forecast turns in the business cycle. If Capital Economics is correct, and they are not alone in this view as other independent research supports it, the effects of central bank easing this year is finally is kicking in to stimulate economic activity and global growth is bottoming.