Posted: May 17, 2023
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What to Watch this Week
Wednesday (May 17th)
- Eurozone CPI
- Bank of England Governor keynote speech
- U.S. housing starts
Thursday (May 18th)
- U.S. initial jobless claims
- Conference Board leading index
- Existing home sales
Friday (May 19th)
- Japan CPI
- ECB President Christine Lagarde participates in panel at Brazil central bank conference
- New York Fed’s John Williams speaks at monetary policy research conference in Washington
- Fed Chair Jerome Powell and former chair Ben Bernanke to take part in panel discussion
Top News Last Week
1. U.S. Consumer Credit Shows Signs of Stress
According to a report released by the Federal Reserve Bank of New York on Monday (May 15th, 2023), U.S. households added $148 billion in debt in the first quarter of 2023, bringing the total debt balance to $17.05 billion (up $2.9 trillion from before the pandemic).
For the first time in 20 years, credit card balances were flat in the first quarter. This bucks the trend as we typically expect year-end spending to surge during the holiday season.
New mortgage saw a sharp decline in the first quarter, to $324 billion, the lowest since 2Q2014. Mortgage debt makes up ~70% of the total U.S. household debt. Those who locked in lower mortgage rates have tapped into another source of credit – home equity line of credit. Balances on home equity lines of credit increased by $3 billion at the start of 2023.
While overall delinquency rate still remains at historical low of 2.6%, we are starting to see increases in delinquency rates of credit card and auto debt.
2. State of U.S. Commercial Real Estate
The U.S. commercial real estate sector has been constantly making headlines recently thanks to a confluence of factors.
Trifecta blow to commercial real estate
First, the work-from-home and increased retail activity on e-commerce channels has sent waves through the office market and retail landscape, especially for lower-tier shopping malls.
Second, as the Fed embarked on the fastest and largest rate hikes in several decades, the commercial real estate sector is coming under increasing stress. With lower occupancy rates and higher interest rates to service their debt, commercial real estate owners are getting squeezed.
Third, the regional banking crisis has seen tightening in lending standards, as reported in the Senior Loans Officer Survey released last week. These commercial real estate owners are heavily dependent on debt. Amidst such an environment, securing refinancing may prove to be trickier than before.
~$2 trillion of CRE loans coming due by end 2025
According to Alliance Bernstein, ~$6 trillion of U.S. commercial real estate debt remains outstanding — $2 trillion is multi-family (such as apartment buildings), while other property types account for the rest.
Half of the lending to multi-family are from government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac; banks, insurers and other investors account for the remainder.
Beyond multi-family, regional banks account for half of CRE lending. Just like how the commercial real estate market depends on banks for financing, the small banks (non-top 25 by assets) are equally reliant on the commercial real estate market to drive financial performance.
CRE loans makes up 43% of small banks’ total loans but only 13% of their larger counterparts. As smaller regional banks come under scrutiny, the amount of CRE loans are coming under increased scrutiny especially after the recent bank runs due to liquidity mismatches.
Banks have generally made first lien (most secure) loans at 50-60% loan-to-value (LTV) ratios, giving them some degree of buffer amidst reduced cashflow faced by CRE. That said, almost $2 trillion of CRE loans are set to mature by the end of 2025.
Slowing deal activity in private markets
As the combination of tightening credit and lowered demand of CRE calls into question the valuation, the private market for CRE have mostly seized up. Buyers and sellers find it hard to agree on pricing given the lack of recent comparable transactions and cap rates.
The public market and private market valuations have also started to diverge, with public market REITs getting punished harder.
Net operating income remain healthy
Despite the gloomy outlook, net operating income remain strong from 2022 through to 2023. The office sector remains the black sheep with rising vacancy rates across major metropolitan areas in the U.S. and other countries.
According to Preqin, over $160 billion of capital was raised by global real estate private equity funds in 2022 while North American real estate PE funds have ~$240 billion in dry powder. The substantial amount of dry powder will serve to backstop significant falls in valuation.
3. Debt Ceiling not Raised Following Joe Biden’s Meeting with Congressional Leaders; Biden to Shorten Travel for Further Negotiations
In case you are not familiar with the debt ceiling, here is a primer!
After failing to come to an agreement to raise the debt ceiling last week, the president and U.S. congressional leaders are set to meet today (May 16, 2023) to have another go at it.
The staff have worked through the weekend and President Joe Biden has signaled that the debt ceiling talks are “moving along”.
Reuters has put together a comprehensive explainer on the positions of Republicans and Democrats on the topics of top-line discretionary spending, deficit reduction, taxes, education and social programs, and the Internal Revenue Service (IRS).
U.S. Treasury Secretary, Janet Yellen, warned last Friday that it had $88 billion of extraordinary measures left to help keep the government’s bills paid. This was down from $110 billion a week ago.
The International Monetary Fund, alongside Janet Yellen and many industry thinktanks, have warned of serious repercussions if the U.S. fails to raise the debt ceiling.
After failing to reach an agreement on Tuesday’s meeting, President Biden has scrapped planned visits to Australia and Papua New Guinea, due to take place after Japan’s G7 meeting, in order to return to the US to resolve the debt crisis. The cancellation comes after Republicans, including House Speaker Kevin McCarthy, heavily criticized the president for his upcoming travel plans as debt negotiations continued.
Note that the G7 meeting is scheduled for 19-21 May – this leaves the U.S. with approximately one week to reach an agreement to raise the debt ceiling. The stock market reacted violently the last time the U.S. cut a deal 2 days before the X-Date.
President Biden and congressional leaders remained optimistic that a bipartisan deal will be reached within the next few days. Biden also mentioned that there is an overwhelming consensus that defaulting on the debt is simply not an option.
Meanwhile, JPMorgan’s Jamie Dimon said the bank has convened a war room to prepare for the possibility that the U.S. defaults on its debt in the coming weeks.
4. Fed’s Inflation Fight – Further Hikes not Ruled Out
After the latest 25bps hike, the target Fed Funds Rate is currently at 5% – 5.25%. However, Fed officials have signalled that they might not be done yet. The Federal Reserve will likely need to raise interest rates further and hold them higher if U.S. price pressures and jobs market show no sign of slowing.
U.S. CPI increased 4.9% year-on-year in April 2023, the smallest 12-month increase since April 2021, with food prices rising 7.7% y-o-y while consumer energy prices fell 5.1% y-o-y. This is still more than double the Fed’s 2% target.
Source: U.S. Bureau of Labor Statistics
Credit Tightening by Lenders
According to the Senior Loan Officer Opinion Survey, lending officers at major banks have tightened standards and saw weaker demand for commercial and industrial (C&I) loans and commercial real estate (CRE) loans over 1Q 2023.
Lending standards have tightened for residential real estate (RRE) loans as well. There was also weaker demand for RRE loan in 1Q 2023.
The most common tightening of lending policies for all categories of CRE loans relates to wider spreads of loan rates over bank’s cost of funds (i.e., charging higher interest rates) and lower loan-to-value ratios (i.e., borrowers can borrow less than before).
Bank respondents have cited increased uncertainty in economic outlook, reduced tolerance for risk, deterioration in collateral values and concerns of banks’ funding costs and liquidity positions as reasons for tightening.
U.S. federal budget surplus fell to $176 billion in April 2023, down from a record $308 billion in April 2022. Receipts fell to $639 billion, down from a record $864 billion in April 2022, while spending fell $93 billion to $462 billion in April 2023.
Note that the budget surpluses are usually recorded in April due to a large inflow of tax payments.
The U.S. producer prices rose 0.2% month-on-month, beating economist estimates of 0.3%. In the 12 months through April, the PPI rose 2.3%, the lowest increase since January 2021. Most of the gain in producer prices was due to an increase in services price.
U.S. Core PPI rose 3.4% yoy, down from 3.7% in March. This is also the lowest in two years.
Source: U.S. Bureau of Labor Statistics
Emergency Lending to Banks
According to the Federal Reserve, emergency lending to banks rose $92.4 billion in the week ended May 10, up from $81.1 billion the week before. Bank borrowing from the Fed peaked at $164.8 billion in mid-March.
Bank loans form the Fed’s emergency Bank Term Funding Program totaled $83.1 billion, up from $75.8 billion in the prior week. Bank borrowing from the Fed’s traditional discount window rose $4 billion to $9.3 billion.
Initial jobless claims rose by 22,000 to 264,000 in the week ending May 6, 2023, marking the highest level since October 2021. The rise in jobless claims has continued since the end of January 2023.
According to the University of Michigan’s gauge of consumer sentiment, the preliminary May reading of 57.7 marked a sharp drop from 63.5 in April. This comes on the heels of renewed fears of the U.S. economic outlook.
Despite a continued decline in overall commodity prices since mid-2022, inflation has remained stubbornly strong. The declining commodity prices also forebodes a global growth slowdown as demand for commodities, needed in production of goods, see a corresponding drop.
5. G7 looks to Deter China Economic Coercion
The Group of Seven (G7) is an intergovernmental political forum comprising Canada, France, Germany, Italy, Japan, U.K. and U.S.
The G7 countries will be meeting in Hiroshima, Japan for the G7 summit from May 19 to May 21. China is set to be the key focus as the trade ministers have expressed “serious concern” about economic coercion last month.
According to Reuters, the main G7 statement is set to include “a section specific to China” with a list of concerns that include “economic coercion and other behaviour that we have seen specifically from the [People’s Republic of China]”. A separate economic security statement will elaborate on the tools used to counter coercive efforts from any countries responsible.
Currently, talks are underway by G7 finance leaders in Niigata, Japan, as they focus on reducing over-reliance of their countries’ supply chains on Chinese manufacturing by partnering with low- and middle-income countries.
The U.S. has put forth a position to take target controls for outbound investments to China, however other G7 nations remain skeptical of the idea of investment controls given the potentially huge impact on global trade and investment flows.
Beijing has been accused of using trade policy to target countries including Australia, Japan and South Korea over diplomatic disputes. Japan has invited the leaders of both countries and other nations to attend outreach sessions at the summit.
China has repeatedly hit back at allegations of coercion, saying the US is guilty of using such methods itself.
6. Big Banks to pay Billions in Extra FDIC Fees After SVB Failure
The Big U.S. banks face billions in extra fees under the FDIC’s plan to replenish the government’s deposit insurance fund after SVB and Signature Bank’s rescue. The move to rescue SVB and Signature Bank by backstopping uninsured depositors is estimated to cost about $15.8 billion.
While the plan has not been finalised, the FDIC made clear that big banks will be paying for this. Lenders with more than $50 billion in assets would pay 95% of the fees while those with less than $5 billion will not pay anything.
More Stringent Banking Regulations to Come
Jamie Dimon has also called for regulators to help put an end to turmoil in the banking industry. Dimon foresees “more regulations, more rules, and more requirements” for the banking sector in the days ahead. Dimon and many others have called for an investigation into short sellers as part of the solution.
As emergency funding continues to be drawn at an increasing rate, we are not out of the woods yet. Any possibility of a debt default following a hypothetical failure to raise the debt ceiling could cause more fears and more “bank walks”.
Short Seller Investigation
Short sellers of U.S. regional bank stocks are now under the spotlight after profiting more than $7.5 billion so far this year. On May 10th, Reuters reported that Federal prosecutors in Washington are looking into short selling activity around the recent volatility in U.S. bank shares.
Most Institutional Investors Sell Bank Stocks while one Takes a Contrarian Trade
Since the start of the year, Warren Buffett has sold off most of his bank stocks, except Bank of America, and has recently bought Capital One. Bridgewater Associates, the world’s largest hedge fund, also confirmed that it has exited positions in five U.S. banking giants: JPMorgan, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley.
Meanwhile, ‘Big Short’ investor, Michael Burry, takes a contrarian trade and bought up shares of First Republic, PacWest, New York Community Bancorp and Alliance Bancorp in 1Q 2023.
7. Bets on Credit Default Swap 2 Months After Credit Suisse AT1 Writedown
Warning: this one is a bit of a convoluted one…
A derivative panel tasked with overseeing the market will rule if a credit event has occurred.
A credit default swap (CDS) is a financial contract that acts very much like insurance. In this case, it is an insurance that offers a payout if a credit event (e.g., default) occurs.
2 months after the “surprising” move to writedown Credit Suisse Group AG’s Additional Tier 1 (AT1) bonds, the focus is now on a specific group of Credit Suisse’s CDS. The CDS contracts written against the bank bonds were split into senior and subordinated, according to the seniority of the debt.
Most of the buyers of Credit Suisse’s CDS had assumed that there would be no payout on these contracts as a result of a precedent set almost a decade ago. In 2013, the CDS holders of Dutch bank, SNS Reaal, received no payout even after the government zeroed its subordinated bonds.
In 2017, regulators zeroed Spanish bank, Banco Popular’s Tier 2 bonds in tandem with AT1 writedowns. This led to the full payout for those who bought CDS protection on Banco Popular’s subordinated bonds.
Apart for ‘senior’ and ‘subordinated’ bonds, a bank’s capital structure also consists of other multiple tiers of debt. Tier 2 bonds are also classified as ‘subordinated’ debt.
In the case of Credit Suisse, the Swiss authorities have left its Tier 2 bonds untouched despite having similar writedown clause. Hence, most CDS buyers agreed that no payout will be handed to them.
Furthermore, AT1 bonds are meant to have perpetual maturities (i.e., they never get repaid). This clashes with the requirement in standard CDS contracts that the relevant bonds have a maximum maturity of 30 years.
A group of US hedge funds, including FourSixThree Capital and Diameter Capital Partners, have loaded up on Credit Suisse CDS aiming to profit from a ruling that the swaps have in fact been triggered. (Read the full explainer by the Financial Times).
8. China Reopening Trade – Bull Trap or a Great Buying Opportunity?
‘Big Short’ investor, Michael Burry, has bought more shares of JD.com Inc, and Alibaba in the final months of 2022 – yet another contrarian trade that deviates from other hedge funds. The two stocks now form 20% of Scion Asset Management’s portfolio.
His stake in JD.com more than tripled to 250,000 shares, worth $11 million, or 11% of his portfolio. He also doubled holdings of Alibaba to $10 million.
China reopening trade has been lackluster thus far. The MSCI China Index is flat for the year as the economy shows signs of losing momentum. China’s consumer spending and industrial activity grew at a slower pace than expected in April, underscoring the recovery’s weakness. Youth unemployment rate surges to record high of 20.4%.
According to Goldman Sachs, hedge funds’ net allocation to China has also dropped by close to 3 p.p. from 13.3% in January to 10.5% in May.
Wall Street Pulls Back from China
Big Wall Street banks have also pulled back on expansion plans in China. Goldman Sachs and Morgan Stanley are amongst banks scaling back expansion plans and profit goals in China amidst the deteriorating geopolitical climate and President Xi’s willingness to sacrifice economic priorities for security concerns.
Morgan Stanley is also planning for further cuts to its APAC investment banking team, joining JPMorgan and others in reducing China-dedicated headcount.
China’s Economic Recovery Loses Momentum
Following a strong recover in consumer and business activity early this year, China’s industrial output, retail sales and fixed investments data grew at a much slower pace than expected in April. This is especially worrying given the high unemployment rate of 20.4% among young people.
While industrial production rose 5.6% y-o-y in April 2023, this is lower than the 10.9% median estimate according to Bloomberg’s survey of economists.
Several other signs show a slowdown in economic activity as well: property investment contracted 16.2% y-o-y in April 2023; output of key commodities used in construction like aluminum and steel fell m-o-m in April 2023.
9. EU Backs Plan to Reduce Economic Reliance on China
On Friday (May 12), EU foreign ministers gathered in Stockholm. The ministers gave broad backing to a plan to adjust policy on China to reduce its reliance on China while continuing to see Beijing as a partner on global issues and an economic competitor.
Russia’s invasion of Ukraine shone light on the EU’s dependency on Russian gas. Today, the EU is also heavily dependent on China for key technologies such as solar PV panels. EU ministers stressed that this is not a move to de-couple the European and Chinese economics but to de-risk and rebalance the relationship.
The plan is the latest attempt to strike a balance between views of the EU’s 27 member countries, keep a distinctive EU approach to Beijing and preserve a close partnership with Washington, which is pushing for a harder line on China.
China has warned that it will react strongly if the EU sanctions its companies. This comes after the EU executive arm proposed extending strict trade restrictions to several Chinese companies for supplying Russia with dual-use goods that can be used for both military and civilian purposes.
10. Full Steam Ahead for Japanese Markets?
Japanese equities are on a roll this year, with the TOPIX (Tokyo Price Index) up more than 13% YTD, close to its highest level since Japan’s notorious market bubble burst in 1989. Meanwhile the Nikkei 225 index has gained more than 16% YTD and is closing in on a post-bubble high.
Barring the NASDAQ Composite Index, the TOPIX and Nikkei 225 are amongst the top-performing indices so far this year.
Earlier this year, Warren Buffett indicated his interest to add to Japanese stocks after acquiring more than 5% in each of Japan’s top five trading houses — Itochu, Mitsubishi Corp., Mitsui & Co., Sumitomo Corp. and Marubeni. Berkshire Hathaway also issued ~164 billion yen (US$1.2 billion) of bonds in April 2023, in anticipation of potential policy tightening by the Bank of Japan. The firm’s 5-year note was priced to yield 1.135% according to Mizuho Securities.
Japan’s stocks reached 33-year high on Tuesday following hopes of higher governance standards and more serious regard for shareholders. This comes on the back of an inflow of foreign investors ploughing into stocks and futures since April 2023 as the Tokyo Stock Exchange (TSE) recorded net inflow of US$30 billion.
Apart from excitement around the shift in corporate priorities, investors also have the perception that investing in Japanese companies is a safe way of gaining exposure to Chinese growth without the geopolitical risks. Many Japanese companies offer exposure to China through exports or because they stand to benefit hugely from Chinese travel to Japan.
Japan has long been plagued with tricky corporate structures and lackluster returns, causing fund managers to steer clear. In the time that Japanese stocks took to recover from the 1989 crash, US equities have more than 10-fold.
This attributes have led investors to believe that Japanese equities are undervalued, high-earning stocks that can ride on the tailwind of improving corporate governance.
That said, according to Bank of America’s Global Fund Managers Survey (FMS), respondents were a net 11% underweight Japan. While not relevant to the topic of Japan, BofA’s FMS surprisingly showed a rotation out of commodities and China into tech stocks.
Per my own experience, investors in the Chinese private markets have been sitting on the sidelines and taking a “wait and see” approach since early 2022. Those that are open to investing are only keen to invest at a significant (50-60%) discount to NAV.
11. Private Credit: the New “In” Thing
Last week, BlackRock Inc., the world’s largest asset manager, committed to capitalizing on the growth of the private markets and is seeking to build more teams focused on private credit and direct equity strategies.
The global Head of Credit, Jin Keenan, will now pivot to focus exclusively on private credit. Edwin Conway, who is currently in charge of BlackRock’s alternatives unit, will now lead a group devoted to venture, private equity, infrastructure, growth equity investing, and sustainability investments.
This week, private equity giant TPG announced a $2.7 billion acquisition of Angelo Gordon to grow its private credit business. According to TPG, Angelo Gordon’s platform offers capabilities across the credit investing spectrum, including corporate credit, special situations, direct lending and structured credit – each carrying substantial opportunities for significant organic growth.