Head-over-heals in debt

Takeaway: The IMF’s warning about global debt levels comes at a time when it looks like investors can’t seem to get enough of corporate loans and bonds– even if yields dip below zero. But there are increasing signs that central banks might be calling time  – at least on further QE – and may even tighten policy as the pendulum moves back to fiscal stimulus. Sluggish growth will require central banks to keep their foot on the pedal to some extent, but what happens if they decelerate? Are last night’s events a sign of things to come?

 Debt, debt and more debt….

The IMF report on the global economy makes for chastising reading. There’s only marginally good news for the UK with the IMF following other agencies in upgrading their forecasts for 2016, but downgrading for 2017. BREXIT is a slow burn.  Global growth doesn’t offer much comfort, just at 3.1% this year and 3.4% next, held back by insufficient demand and an overhang of debt. Sound familiar?  It should, since that’s been the refrain for almost a decade now.

 The IMF reports that global debt is now US$152t – or 225% of GDP. This is an all-time high, i.e. more than before the global financial crisis. This debt is mostly private – for now. The IMF is concerned that another crisis will make it public and in the meantime, it will put a lid on demand, keep banks weak, hold back investment and generally keep growth low – which is contributing to social tensions.   Of course low growth isn’t the only trigger for the rise in anti-globalisation thinking, but it can’t help.

The Catch-22 here is that high debt holds back growth, but growth is needed to reduce debt. Thus the IMF continuing their push on further fiscal stimulus and debt forgiveness – including some for banks. As the last few weeks amply illustrate: banking isn’t out of the woods.

 Still dancing…

Over the summer the music played on and companies kept dancing. Central banks hinted at more help – the Bank of England promised corporate QE and debt issuance rose to $5.02t in the nine months to September 22, according to Dealogic. This puts 2016 course to beat the all-time high of US$6.6t recorded in 2006. Corporate issuance of investment-grade debt reached a record high of US$1.54t since the start of the year, up from US$1.41t in the same period a year earlier.

And, as S&P points out, investors’ appetites are undented – even at this pace and  even when more than US$13t of debt trades with a yield below zero.  There were been some blips and nervy moments, but they haven’t lasted long. This year the sterling corporate bond market saw its busiest ever August.  Roughly US$179b has been added to global bond funds this year.  Prices are trending down.  PIKs are back. The loan market has been boosted by the return of the CLO market. We’ve recently seen the issuance of two European negative yielding corporate bonds – which make more investor sense when you put in the context the 0.4% banks have to pay to keep money on deposit at the ECB.

 This all sounds very 2006, but so far we haven’t seen companies get really aggressive in structures or leverage. Deals are mostly refinancing. Nevertheless, the dance depends on central banks playing on…and on…

Are central banks turning the music down?

We’ve been here before – the point where it seems that monetary policy can’t possibly get any easier….and then it does.  Given the weak global outlook, a substantial tightening of policy looks most unlikely. These should remain relatively easy conditions for companies to borrow. But – and going back to the IMF’s point – what’s changed is that governments are starting to recognise the negative impacts of QE on wealth distribution, the corrosive impact of inequality and the limits of monetary policy to stimulate further demand.  The IMF doesn’t want to see the end of monetary stimulus, but the end of such heavy reliance on central banks:

 “monetary policy alone won’t restore vigor to economies dogged by slowing productivity growth and aging populations”.

 So, in contrast to the summer, we now see the UK government cooling on monetary stimulus and the pound’s overnight plummet – that’s not really being reversed in daylight – will further limit room for manoeuvre. Inflation expectations have shot up overnight. The Bank of Japan has also called a time-out on more QE. The Fed is moving towards further tightening – maybe in December, although today’s non-farm payrolls run contrary to other more positive data. The ECB’s position is much more complicated. Sovereigns in the Eurozone remain reliant on support – Portugal maybe more so in the coming weeks, not to mention some banks.

Therefore, we may not see a major pull back, but – as we’ve seen before – even a slight change in tone can cause ripples across the market and maybe QE shock absorber effect is waning.. The benchmark 10-year government bond yields of Germany, France, Italy and Spain jumped about 4 basis points in the space of an hour on the Bloomberg story that the ECB might wind down its bond purchases early. Sterling’s fall is being interpreted in many ways, but one thought is that markets are starting to react a little more to market shocks.

Just this week – as the FT reminded us this morning – Bank of America Merrill Lynch warned that trading conditions in the currency markets were creaking. Traders, it warned, were “complacent” over the risks of market shocks. “Phantom liquidity haunts the market,” it warned, creating an “illusion of stability”. It stated – with some prescience – that FX trades now have a 60% greater impact on prices for any given size than they did in 2014 because “liquidity may not be present when investors need to transact with urgency.”

October is often an “interesting” time – this one looks likely to live up to the month’s volatile reputation.