With each crisis, new opportunities are created. A banking crisis can even be an impetus for the next bull market since all too often a financial crisis is a trigger for a monetary policy adjustment. In fact, the Great Financial Crisis was followed by the largest bull market ever. With interest rates at zero, there was no alternative to equities, with U.S. CEOs and CFOs also feeling the panting breath of private equity investors breathing down their necks (although executive employee stock options in themselves created a strong focus on the stock price) and began optimizing their balance sheets. With interest rates at zero - and as a result, extremely low credit spreads - the cost of debt was so low that there was plenty of borrowing to buy back shares. Year-on-year, companies themselves were the biggest buyers of their own shares.
In recent weeks, apart from the financials, stocks have been moving sideways on balance. As a result, virtually every asset class has posted positive returns for the first quarter (with a few days to go). Perhaps remarkable given the fuss about higher-than-expected inflation, resulting in more central bank interest rate hikes. Not surprising considering the negative mood at the end of December. As many as 85 percent of economists then counted on a recession. That percentage fell all the way to 20 percent but has since risen again
A recession is not good for corporate earnings, but there is a big difference between a deflationary recession and an inflationary recession. After all, stock gains are nominal. Ex ante, it doesn't matter so much whether sales rise due to inflation or increased demand. Inflation itself can therefore provide higher margins. What entrepreneur doesn't like being able to charge higher prices? Ex-post, what matters most is the effect of inflation on costs. A company with few employees, no debts, low energy consumption, high margins, and sufficient pricing power benefits from higher inflation in such a case. On top of that, this type of company may have competitors that are heavily financed or less efficient. These companies are more likely to run into trouble in an inflationary recession. For the earlier company, one less competitor. As a result of the monetary madness in which interest rates were at zero or even negative for years, many of these companies were able to compete fairly easily with companies that had no debt. That period persisted for a long time, resulting in an increasing number of companies that, at normal interest rates of say 4 or 5 percent, do not generate enough cash flow to pay the interest on the debt. Those companies are not in acute trouble as long as the existing debt is still financed at that historically low-interest rate. However, there comes a time when the debts have to be refinanced at then-current terms. Then such zombie companies acutely collapse.
One asset class that is likely to end the first quarter with a minus is the High Yield category. This is not because of interest rates, but mainly because of credit spreads. This is where the major distinction between investment-grade corporate bonds and high-yield corporate bonds comes into play. The former category is much more sensitive to interest rates and much less to credit spreads, while the much shorter-term high yield is primarily concerned with credit spreads. From a historical perspective, a credit premium for a high yield of 5 percent is not even extreme, but insufficient to get into now. Keep in mind, however, that the absolute fee is not unreasonable. The initial yield on U.S. high yield is now close to 9 percent. More than 9 percent is now achievable on the subordinated paper of financials. Several loans now have yields above 10 percent. The question now is whether the reward is sufficient for the risk or whether that comes after 10 zero. For example, there is much debate about the Swiss government's treatment of the Cocos. Shareholders got a fraction of their shares, but the theoretically higher-ranking deeply subordinated bondholders got nothing. Incidentally, the material difference is minimal. Still, this little mouse may have a tailspin. After all, many investors think in cubicles. That is why there are sometimes extreme differences between stocks and bonds. For example, there are very good quality companies where the dividend is a multiple of the interest paid on debt. That while the dividend tends to follow earnings trends (at least often inflation) every year. The bond coupon then remains the same. The big question is whether the discussion of Cocos will now lead to a new asset class, the paper subordinated to normal stocks that resemble a bond. If it can no longer be called a bond, this category is suddenly vulnerable. In this respect, it most closely resembles a written put. Even then, the shareholder can get away unscathed while the option holder loses everything. Only, the appeal of such a written put packaged as a bond is in the classification. As long as such a bond is classified as a bond, the return looks much better than on numerous other bonds. But as soon as such a deeply subordinated bond is an alternative to a direct investment in stocks, it is a different story. Then suddenly there are no more billions available to invest in them. If the Credit Suisse discussion shows that, for example, Cocos in its current form are an ill-perceived or an ill-conceived product and would be better marketed as a written put option, price pressure may increase.
Still, for an investment in banks, this deeply subordinated paper is probably a better alternative than investing in bank stocks. The average return on equity had finally rebounded years after the financial crisis to its high of 9 percent, but this is now being expertly killed by this banking crisis. Higher capital requirements and more regulation are crippling returns. For the shareholder and given the risk, a 9 percent return on equity is actually insufficient. If you look back from the absolute bottom in 2009 to see how financial sector stocks have performed, you see an annual outperformance of 1 percent, which is also very meager given the high risk. The business model of banks is dead. Paying has already been taken over by fintech companies that make hefty profits from it, whereas paying at banks used to be a vessel of side deals. Private debt today is one big category where investors play bank, but with more returns and less risk. What remains is a kind of utility function that might be better outsourced to the government. Banks themselves can only be saved with the necessary subsidies from the government or the central bank. For many politicians this is unacceptable, but in fact, many of the central bank's programs in recent years have been real support programs for the banks. In that respect, it is sour that things are now going wrong again. As we approach the end of the credit cycle comes the time to look again at that extreme end of the credit spectrum. Besides High Yield, Coco's, by the way, one can also think of distressed debt. Typical categories where what matters is not time in the market, but timing. With the liquidity crunch, the fee for those seeking to provide liquidity is relatively high. However, the king's robe is quickly digested. Especially when opportunities abound, liquidity to invest is a great commodity. Better times are likely to come.
Comments