Saturday, September 06, 2014
Beware of the Coming Winter of Discontent
In investing, as in life, timing can be everything. The cycles of the capital markets are as immutable as are the seasons of the year. Those who commit risk capital while the cycle is enjoying its risk-on spring will prosper; those who avoid risk-taking during the spring would be well advised not to do so as the autumn chill approaches.
Shockingly, as critically important as it is to take the measure of financial and economic cycles, there is precious little insight offered in terms of understanding what drives them. The ability of our institutions to forecast, much less control, cycles has been exceedingly poor. Need proof? Inspect the pronouncements of our high priests and priestesses of finance at the Federal Reserve. In June 2008 — three months before the failure of Lehman Brothers and the takeover of Fannie Mae and Freddie Mac — the Fed expressed its concern over rising inflation and reiterated its expectation that growth would continue.
My point isn’t to lambaste the Fed, which — like the U.S. government, Wall Street and the media — failed to perceive the severity of the financial fragility that had developed during the housing bubble. Rather, my purpose is to remind that the customary ways of understanding and measuring cycles are nearly useless and investorsneed to examine them in a new, or at least different, way.
Traditionally, two basic narratives have been used to explain cycles: Recessions happen because businesses become infused with an excess of animal spirits. Overexpansion begets an unwanted build in inventory, forcing the shuttering of production until inventory is worked down to a manageable level, at which point normal growth is restored. Now, does that sound like any business cycle you’ve seen in the past 30 years?
Alternatively, some claim that the imbalance comes not from business but from consumers. They get exuberant, go on a shopping spree and spur inflation, compelling the Fed to pull the punch bowl. Once it is removed, consumer spirits dampen, and the cycle concludes. Well, does this sound like 2008? Was inflation such a menace that the Fed raised rates to flatten growth?
So if the usual suspects have little to do with the demise of the cycle, then investors ought to look elsewhere to more properly gauge its longevity. A study of the deleveragings of the past quarter century provides the necessary guidance: Simply put, we have lived for some time in an integrated global economy mirrored by a globalized financial system. This means that the credit cycle and the business cycle have become almost one and the same.
Provided that the capital markets are willing and able to extend the frontiers of credit that one extra step, so long as one more marginal loan can go to that one more marginal borrower, we maintain growth. But once the high-water mark in credit is reached, a deleveraging inexorably builds momentum (either over several quarters or within the context of a market crisis, when it happens over days or weeks), and an economic downturn is under way.
The implications for investors are clear. Main Street economic indicators — car sales, purchasing manager surveys, employment data, housing market activity, asset prices — are highly dependent upon the willingness of the capital markets to engage in the lending activity that fuels a releveraging economy. The notion that high asset prices and a low level of unemployment inoculate the economy from downturns is belied by history. Did such a peak in stock and real estate prices prevent the cataclysm of 2008? Did the sub-5 percent unemployment of early 2008 mean that the virtuous jobs-income-jobs cycle had firmly and forever established itself? Obviously not.
If you want to understand how old the current cycle is — that is, how risky a commitment to risk-based assets might be — then it is critical that you judge the quality and durability of underwriting standards in the capital markets. A recovery that is predicated on the continued production of loans, too many of which will ultimately go bad, is no recovery at all. Rather, it is a condition that supports current economic activity at the expense of a future write-down in loan and asset valuations.
Yes, conditions appear better, but the house of recovery is increasingly being built out of credit straw rather than brick and, consequently, will not withstand the gales of the tighter credit to come. Whether these tighter conditions come naturally, via a capital markets self-realization of the excesses, or by the Fed’s need to raise rates in response to the risk or reality of higher inflation, the result will be the same: a deleveraging and possibly recession. For this reason, we at TCW have steadily reduced our exposure to rates and to risk-taking in credit with the expectation that an inevitable winter of higher rates, wider risk premiums and higher volatility lies ahead.• •
Tad Rivelle is CIO for fixed income at TCW, which manages over $140 billion in assets globally.
Posted by Bud Fox at 6:34 PM