Tad Rivelle, Chief Investment Officer of the Californian bond house TCW, doubts that the Central Banks can prevent the impending economic downturn. He spots increasing signs of stress in the credit sector and recommends holding safe assets to be prepared for turmoil in the financial markets.
Mr. Rivelle, who rarely gives interviews, views the prospects on the financial markets with skepticism. In his opinion, it’s clear that the business cycle is in its final stages. He warns that the power of unconventional monetary policy is largely exhausted and nervousness in the credit sector is growing.
Against this background, he advises a defensive calibration of the portfolio and a careful approach when it comes to security selection – especially in the investment grade segment where many companies are more leveraged than their rating indicates.
Mr. Rivelle, the rally in stocks has lost some of its momentum recently. Nevertheless, the S&P 500 is near its all-time high. What’s your take on the current market environment?
We’re very skeptical of taking risks in this market since there is fairly abundant evidence that we’re in a late cycle type of environment. Equity valuations are largely following the script of the central banks: The central banks say dance, and the equity market is dancing. In contrast, debt investors increasingly say: «There is nothing in it for me to get on the dance floor because as a debt investor, all I get back is a 100 cents on the dollar». We’re the asset class that’s always at risk of loss. The Federal Reserve can say and do whatever it wants. But if it can’t get the private sector to follow through with cheap financing and debt markets become skeptical of providing favorable financing, I don’t know where you go with that.
Globally, there’s around $ 12 trillion in negative yielding debt. How do you approach such a market as a veteran fixed income investor?
It’s an absurdity and an artificial condition. For instance, a Swiss company like Nestlé finds itself in some kind of financial paradox: They can issue negative yielding debt in Swiss francs and then use the proceeds to buy back their own equity. If you want to reflect on this philosophically: Why have any equity at all? You could just buy it all back. That leads to the next observation: Your assets theoretically are producing benefits and your liabilities are producing benefits, too. This would imply there’s no cost running your business at all. This is obviously a hint that markets didn’t get to negative interest rates through a negotiation process between borrowers and lenders. Rates were pushed off the cliff by the central banks.
What are the consequences of these artificially low interest rates?
The collective and extraordinary expansion of central bank balance sheets has powered the «bull market in everything». But these absurd policies aren’t going to work for the long term. In this cycle, the Zeitgeist has been that the central banks have the capacity to maintain growth and prosperity. In others words: If you control the financing right to corporations and consumers, you can make the economy grow forever. This flies in the face of common sense. Economics used to always be about the idea that you need to incentivize producers to make efficient choices. If you give them the right incentives, they will raise the bar in terms of value addition and growth over time. But when you artificially chose your rates, you are doing the opposite. You’re causing bad choices by definition.
Where are such bad choices evident today?
The low rate environment has created excesses in a lot of areas. It has driven up asset prices, and as you drive up enterprise multiples, you drive up leverage multiples. Look at private equity: The best idea that most institutional investors say is in their portfolio is private equity. That’s strange since the whole concept of private equity is basically that you buy up businesses, you put a lot of leverage underneath them, you don’t mark things to market - at least not the same way as the public markets do - and you create this illusion of low volatility investments. So you have a system where company managers get enabled to say ridiculous things to their investors like: «We don’t care about profits». I don’t think we would have a company like WeWork if we didn’t have an environment where investors are thinking that they need to invest in a fairy tale because they can’t earn a return any other way.
What’s your take the WeWork disaster?
WeWork was one of these situations hiding in plain sight. There were plenty of people who expressed skepticism. Yet, you had money center banks playing along, making loans and adding to the credibility of it. So you had a fairy tale: You had a $47 billion unicorn two or three months ago that now had to be rescued. I’ll go further: If SoftBank didn’t rescue WeWork, would you really want to find out what the lawsuits are going to discover when the Limited Partners sue SoftBank? When they ask: «How did we get to $47 billion, exactly?» And while you’re at it, you might be even doing that in a court in Riyadh. So maybe this point, the best course of action is just to pay everybody off and then figure out what to do.
Where are other disasters hiding in plain sight?
When you get to the last phase of the cycle, you need to be thinking about what could go wrong, because there is very little probably that’s going to go right. Today, a lot of carnage has come to the fracking area. There are a lot of E&P capital structures that are evidently no longer financeable in the capital market. A lot of these businesses are probably going into bankruptcy. Also, you see stress in automotives, in semiconductors and in retail. What’s more, it’s fair to say that the bank loan market represents one of the significant risks out there.
What are red flags investors should watch out for?
The number of high yield credits trading at spreads over a thousand basis points over treasuries has been rising all year long. Also, you’re seeing a lot more volatility in the leveraged lending space. Credit Investors increasingly are firing first, and ask questions later. This speaks back to another of the excesses in this cycle. Traditionally, the deal was that if you are a leveraged company, you were given two choices in the debt markets: Door number one, you can show the world what your financials are, adhere to the public standards, issue high yield bonds and report to the SEC and your debt investors what’s going on. Door number two: If you don’t want to show your numbers you had to get your hands tied behind your back. The lenders will give you the money but they won’t let you do much of anything with it because they want to make sure you’re not doing something stupid while they can’t watch you.
And what’s going on in this cycle?
This cycle, we have moved to an environment where what was a covenant heavy bank loan market has become a covenant light bank loan market. As a debt investor, you don’t have transparency and you have no ability to constructively restrict what management is doing. Private equity plays into this dynamic because it has used its market power to negotiate on behalf of its portfolio companies. So we’ve seen a worsening of covenants and credit agreements. Some of this relates back to a basic dynamic that the Fed and other central banks have put their hand on the scale: They’re basically communicating that they want to make it so easy for borrowers that lenders are saying: «Cash is burning a hole in my pocket. I need to do something with it.»
How does this end?
This is how it all ends badly. Think about the DNA of markets. Let’s say, you want to buy a house. In a red-hot market, you show up at the first day and there’s twenty people looking to buy. You want to do your due diligence and ask about the foundation, the roof and maybe the crazy neighbor. Finally, you get hold of the seller and he’s like: «I don’t have time. I’m not answering your questions. The only thing I want to hear from you is how much over the full offer price you want to pay.» That's the way the credit markets were in 2017. «Drive-by» deals were done and investors like ourselves got the call in the morning saying: «Company XYZ is raising $ 500 million, you’re in or you’re out?» So no time for due diligence.
That doesn’t sound like prudent behavior.
Now, fast forward a couple of years and suppose you’re in a stone-cold housing market. You list your house, you wait three weeks and finally, some barely qualified buyer walks through the door and wants to know about your foundation, your roof and the crazy neighbor. After you’re done answering his questions, he’s got more and more questions because he recognizes intuitively that every time you can’t answer a question, he can make a worse case assumption and use it as justification to knock your price down. So suddenly the market has become completely illiquid and very hostile.
At which stage are we in the credit markets today?
Generally, if you’re involved in a bank loan that doesn’t have the parameters a CLO would naturally buy, the sponsorship is thin. If everything is fine, you probably won’t experience a lot of volatility. But miss your earnings or communicate some bad news and investors drop challenged credits like «hot potatoes.» That’s logical because your business has been operating in the dark. You haven’t told your lenders anything for years. Now, the only news you're giving them is bad news. So they have to assume that this bad news hasn’t just happened yesterday, but there are deeper ongoing issues. They want out, but there is no bid on the other side. That’s why a liquidity crisis is all but inevitable.
How long until these developments evolve into a bigger issue for the financial markets?
We thought it was going to happen two years ago. Credit markets look late cycle, manufacturing looks pretty late cycle and corporate profitability, as well. So the proliferation of negative rates may also suggest that central bank policy has reached exhaustion. It’s almost like negative rates are the last thing central bankers are trying to make it work.
What are the chances of a recession against this backdrop?
It’s a little hubristic to say we’re going to have a recession in the next twelve months. What’s not hubristic is to say that these policies are not working and we will inevitably have a recession. Didn’t we try this at least once or twice before? Didn’t the Soviet Union have zero percent interest rates? Didn’t they have recessions? Maybe it wasn’t visible in the official statistics, but their recessions were manifested by longer lines at food stores.
What have zero percent or negative interest rates to do with that?
Artificial asset prices distort resource allocation and growth. Look at the fact that Sears and Kmart are for all intents and purposes just about to disappear on the scrap yard of history. All the resources invested in stores, labor and capital, are worthless. So the faster you get rid of it, presumably the better off you’re ultimately going to be. Recessions are not optional, they are inevitable. It’s the process in which it’s all getting washed out and rearranged. It’s like: «Don’t you want to get to the passing lane eventually? Or do you want to be stuck in the right line because you’re afraid of change?» Eventually you have to do it anyway.
An important piece of the puzzle is the US consumer. How healthy are households in the United States financially?
The US consumer is divided: You have the middle- and upper-class consumer, which seems to be in fine shape at the moment. You wouldn’t expect differently because consumer proclivity to buy is a function of income, employment and housing prices. So middle class people in general feel more secure with employment as high as today and their house worth 20% more versus what it was ten years ago. On the other hand, the subprime consumer is more credit dependent and metrics there are not really good. We’re seeing deterioration in delinquency rates and charge-offs for the lower range of credit counterparties. The problem is, that this is where a lot of growth ultimately comes from, from the marginal buyer.
What does it mean in terms of Fed policy? Are more rate cuts coming down the road?
Let me be maximally charitably to the Fed: They have no backing by elected officials from either party to do anything but lower rates in response to incremental economic weakness. So it’s fair to say that if the economy weakens they will lower rates more, regardless of what they say. It won’t happen this year, I presume. But I guess in 2020 they’re going to cut rates again. We invented central banks because we figured out that the banking system, if left to its own faith, is too volatile and that we need a state sponsored institution to cushion the blow. But somehow, we went from there to the Fed buying $ 60 billion of T-Bills a month, calling it not Quantitative Easing, and central banks in Europe and Japan imposing negative rates.
What’s the yield on the ten-year treasury going to be in a year from now?
I would say somewhere around where it is today, between 1.5 and 2%. But that’s just a wild guess. It’s a question of timing and causation: If this becomes a global led downturn you have to assume that US rates are going lower. But you can also imagine other scenarios. US rates being above overseas rates has brought huge capital inflows and people are getting very used to the idea that these capital inflows will always hold down US rates. But what’s going to happen when these flows reverse for who knows what reasons and US rates go up?
What should a prudent investor do under these circumstances?
You should adapt your underwriting standards to the kind of environment that you are in. So, beginning a couple of years ago, we adopted our underwriting standards to be much more careful with respect to the types of risks we’re taking throughout our whole portfolio. In other words: Stay vigilant, focus on staying liquid, focus on safe assets and wait for volatility to present opportunity.
So how does a robust bond portfolio look?
It was Benjamin Graham pointing out that bond selection is a negative art. That’s especially true in the late cycle. Cycles die in large measure because capital gets tied up in unprofitable enterprises. So you need to think long and hard about what claims are breakable and can suffer catastrophic and permanent price declines. There may be a time to own breakable assets, but after they break and not before.
What are such breakable assets today?
There will be plenty of breakable assets and a lot of them will be in the high yield and bank loan market. Some maybe even in the investment grade market. Today, 11% of investment grade issuers are levered more than five times, an 27% are levered more than four times. In this context, you could make a pretty good case that 50% of BBB debt would have a high-yield rating based on leverage alone.
Where are better places to invest?
We’re counselling to divide your assets between bendable assets and riskless assets for the liquidity issues that we’re going to encounter. I would put treasuries and agency mortgages as the risk-off, liquid part of the portfolio. You can’t retire on them or really do anything with it. But you can own them tactically to finance the expansion of your bendable assets: Assets that are exposed to mark-to-market risk, meaning they go up and down, so they may be exposed to liquidity risks. But they provide you yield today and their claims will survive into the next cycle, if you have done your categorization right.
What are attractive bendable assets?
Bendable is what we refer to as true investment grade credit. Also, AAA-rated commercial mortgage-backed and asset-backed securities as well as senior non-agency residential mortgage-backed securities. Stuff that we’re invested in obviously. In some cases, AAA-rated CLO tranches can potentially make some sense, too. And, if you can find them, some high yield securities maybe, or a few emerging market securities. You try to find companies with a wide enough moat around what they’re doing, like regulated utilities as long as they’re not in California where you have a special environment with damage claims from wildfires.