For an understanding of how a 2008-style mess comes to pass, and of some of the reasons why we're shifting to an asset mix less correlated to a roaring bull market, I highly recommend Howard Marks's book Mastering the Market Cycle.
...a generous capital market is usually associated with the following:
- fear of missing out on profitable opportunities
- reduced risk aversion and skepticism (and, accordingly, reduced due diligence)
- too much money chasing too few deals
- willingness to buy securities in increased quantity
- willingness to buy securities of reduced quality
- high asset prices, low prospective returns, high risk and skimpy risk premiums
It’s clear from this list of elements that excessive generosity in the capital markets stems from a shortage of prudence and thus should give investors one of the clearest red flags. The wide-open capital market arises when the news is good, asset prices are rising, optimism is riding high, and all things seem possible. But it invariably brings the issuance of unsound and overpriced securities, and the incurrence of debt levels that ultimately will result in ruin.
And here's me from a last-October blog post:
Am I being an alarmist? Am I overstating the risk? Am I just one of those perennial pessimists?
Well, as for that last question, long-time clients (and blog subscribers) know that, if accused of anything, up till lately it would be of being the perennial optimist. As for the other two, I'll let Moody's and the IMF take those:
Moody's this week: emphasis mine...
Investors have maintained a voracious appetite for high-yield debt this year, fueled by post-financial crisis quantitative easing, Moody's Investors Service says in a new report. This has led to high-yield bond and leveraged loan volumes at historical highs, paving the way for unprecedented weakness in companies' capital structures and erosion of their credit quality.
In the past year, loans have become more bond-like, balance sheets more concentrated in first-lien debt and investors have lost more control over debt terms and credit protections, Moody's says. The forces of bond and loan convergence today are as strong as they were 12 months ago, when the rating agency raised concerns about how this trend is causing credit risk to worsen.
According to Moody's analysts, investors will enter the next downturn more poorly positioned. Aggressive transactions and behavior have seen credit quality continue to deteriorate, with the percentage of first-time debt issuers rated B3 at about 40% today, or twice the percentage seen during the 2008-09 recession, adds Padgett. And as this cohort of companies contends with rating downgrades during the next downturn, the ranks of Caa issuers and defaults could also swell beyond 2008-09 levels.
Here's from the IMF's latest Global Financial Stability Report:
While easier financial conditions have supported economic growth and helped contain downside risks to the outlook in the near term, they have also encouraged more financial risk-taking and a further buildup of financial vulnerabilities, putting medium-term growth at risk. Indeed, the analysis presented in this report points to elevated vulnerabilities in the corporate and in the nonbank financial sectors in several large economies. Lower yields have compelled insurance companies, pension funds, and other institutional investors with nominal return targets to invest in riskier and less liquid securities. As a result, these investors have become a larger source of funding for nonfinancial firms, which, in turn, facilitated a rise in corporate debt burdens.
According to the analysis in this report, the share of debt owed by firms with weak debt repayment capacity is already sizable in several major economies and could reach post–global financial crisis levels in the event of a material economic downturn. Furthermore, low rates in advanced economies have spurred capital flows to emerging and frontier economies, facilitating further accumulation of external debt. The search for yield in a prolonged low-interest-rate environment has led to stretched valuations in risky asset markets around the globe, raising the possibility of sharp, sudden adjustments in financial conditions. Such sharp tightening could have significant macroeconomic implications, especially in countries with elevated financial vulnerabilities.
Institutional investors’ search for yield could lead to exposures that may amplify shocks during market stress: similarities in investment funds’ portfolios could magnify a market sell-off, pension funds’ illiquid investments could constrain their ability to play a role in stabilizing markets as they have done in the past, and cross-border investments by life insurers could facilitate spillovers across markets.
…central banks have adopted a more accommodative stance since the previous GFSR, and there has been a policy easing in economies representing about 70 percent of world GDP. Current and anticipated monetary policy accommodation has substantially boosted risk assets (Figure 1.1, panel 1). This change in policy stance appears to have been interpreted by financial markets as a turning point in the monetary policy cycle, following a period of rate normalization in some economies. The shift suggests that a sustained normalization of rates and central bank balance sheets may be more difficult than previously envisioned, especially in the context of weaker global growth and when other central banks continue to pursue quantitative easing.
Believe me, the above doesn't begin to do justice to the full IMF report. If you're so inclined, grab yourself a strong cup of coffee, and have a stiff drink ready for when you're finished. Here's the link...
Note to clients:Our fundamental commitment here at PWA is to always have your portfolios positioned in a manner that captures the opportunities the financial markets have to offer, but first and foremost within the context of the risk/reward setup. Hence, the current hedging...