Everything Everywhere All at Once

By Edward Lim

3 April 2023

We see the chronology of blows up in the past 15 months as inter-connected. It first started with the Fed and many central banks normalizing their post 2008-GFC and Covid largesse. The initial gradual increase in policy rates gave way to an overzealous pace of hiking by the middle of last year. The first to unravel was crypto-currencies and its’ pseudo financial intermediaries, followed by NASDAQ peaking around the same time. Nothing is spared with the bond market having its worst performance in 122 years. Just when we thought we had exposed these “lives” of irrational exuberance that quantitative easing has created; it was soon followed British Gilt mini-crisis and the first substantive markdown in private equity/venture funds in more than a decade. The ongoing March 2023 madness of bank runs and bankruptcies underscored this complex web of connectivity and unraveled fault lines. The first is the assumption that rates will stay low forever and cheap financing will always be available for both public and private companies whose mantra was to grow at all costs. All these bombastic jargons associated with the crypto world are but unadulterated shenanigans. The omnishambles of inept management of banks by both banks’ executives and regulators were dereliction of duties at its best. The craziest irony of this March 2023 madness is that it was facilitated by a dying social media platform. A platform that has just changed ownership to a larger-than-life personality who has boldly declared the platform will be an unbridled cacophony of opinions and half-truths.

Swift actions were pursued to stem a global contagion of the financial system with regulators and eagle-eye investors dusting out their established playbook of protocols, policy tools, and plain sensible good ole bargaining. Of course, special mention must be made about the Swiss National Bank which has made its venerated and centuries-old banking system become a pariah in the international community in just one crazy weekend.

By now, you would surely appreciate the choice of title for this edition. However, we believe the excess “lives” do not just stop here. We see two gigantic risks that could derail our more constructive view of the economy and capital markets at the start of the year. We have stated that while it is likely the world will enter into a mild-moderate recession, the rates and oil markets have already priced in this risk and equities are at the tail-end of its bear market cycle.

But before we unbox these two “lives”, let’s mark to market the inflation dynamics. Our view on inflation remains unchanged where we are expecting inflation to decline throughout the year enough for the Fed to pause sometime in 2Q23 and the ECB in late 3Q or early 4Q23. We have emphasized the key inflation data to monitor are housing (as it forms a large part of the inflation basket), wages (given its ancillary contribution to all items in the basket), and the energy/food complexes (as this is the most optically obvious to the man on the street).

Fed’s preferred inflation indicator continues to trend lower but slower than market is expecting

Source: NDR

The latest PCE and CPI in the US continue to trend lower, albeit at a pace that is slower than what the market is expecting. However, we remain unconcern because leading indicators of housing inflation have significantly abated. The various high-frequency indices of rent are now at zero yoy growth. The number of homes under construction in the US (258,000 homes) and the pipeline of homes construction not started (94,000 homes) are at levels similar to the pre-2008 subprime crisis. The inventory of completed homes has now recovered to 75,000 homes level, which is consistent with the average of the last 5 years pre-Covid. This has doubled the inventory-to-sales from an all-time low of 2 months during much of 2020-21 to 4 months; 2 months short of its 50 year historical average. Home prices across many states in the US are under pressure as inventory increases while demand frays due to higher mortgage rates.

Rents growth has stalled

Home prices are forecast to decline across many states

As we have detailed in Don’t call the car mechanic when it is the bathroom that is leaking, the unemployment rate is a late indicator to track wages as well as the health of the economy. Using data since 1968, we note that in all recessions, the unemployment rate trough before the official start of a recession. In fact on average, unemployment trough 9 months before the start of a recession. Moreover, most of the time, unemployment only peaks after a recession has officially been declared over. In other words, the Fed’s use of unemployment to gauge whether it should pause or to continue to hike is so misguidedly late. For the record, since 1968, the Fed’s track record of engineering a soft landing is limited to only 2 out of 7, and on average unemployment rate rises by 1.80 ppt. The latest actual hourly earnings and forward-looking surveys collaborate with our views that wages will fall quite quickly. We believe it might fall faster than housing and rent inflation.

Wages are slowing

Survey points to further weakness

The cadence of supply chain disruptions on the food and energy prices has slowed even more in the last 3 months. Oil prices are down more than -25% yoy, US pump price has fallen -16% yoy while Natural Gas prices decline on yoy basis are steeper than oil. All the energy complexes right down to coal are seeing declines on a rolling 3-month basis. Wheat prices are down -25% yoy and -12% on a rolling 3-month basis while the broader soft commodities index that includes (wheat, hogs, and orange juice) are down -13% yoy. While readers may dispute these observations given the price of chicken rice has increased or the portion has shrunk, we would argue there are other factors in play such as GST increases (Singapore) or logistical red tape (Brexit), and argue that the moderating prices of primary food ingredients should feed to lower prices in the intermediate term; pardon the pun. Lest we forget, all food-related commodities have a short production cycle.

Energy and food prices are falling

The first connected “life” to unravel is the global commercial real estate sector. Long-time readers would have heard us mention many times that the biggest beneficiary of this dysfunctional monetary policy is that it made every real estate investor a genius. The recent developments in the banking sector have finally short-circuited the liquidity spigot and the days of masquerading interest rate arbitrage as property asset enhancement initiatives are over. Only after the debacle in the Silicon Valley Bank and Signature Bank did we know that the smaller US banks played a disproportionately meaningful role in this sector. Using the US as exemplary tale of caution, we estimate the stock of borrowings from the commercial real estate and retail sectors is at $1.75trn and another $461bn is in construction and land development loans. The loans to these segments have grown 25% from the start of 2019 to February 2023, outpacing the overall banking system loan growth by a mile. 80% of these loans are held by smaller banks with asset size less than $250bn. Aggravating this concentration, regional and local banks’ market share has been increasing, and in 2022 they were the largest lender to this segment.

Small banks account for lion-share of CRE loans

and their market share has increased the most

The sector must also contend with a wall of loans maturing in 2023 and 2024. Of the more than $1.1trn debt maturing in 2023 and 2024 in the entire real estate loans, more than $500bn is related to commercial and retail real estate. If these loans struggle to be refinanced, will there be aftershocks to the entire commercial/multi-family mortgage market which is $4.5trn in size. Aside from the banks, the second largest holders of these debts are agency and non-agency mortgage-backed securities, ie held by fund managers (21%) and life insurers (15%). This will be systematic in nature if defaults increase. Even if they can refinance, it will be at least 2 to 3 times higher than their prevailing cost.

Bulk of 2023/24 loans due are in Office

Can it have a knock-on impact to the larger market?

The fundamentals for this sector are not encouraging as well. After an initial recovery in leasing activity post reopening, interest has fallen in the past few quarters and vacancies have crept up to 2008 GFC high.

Office leasing interest has cooled, and Vacancy Rate is at 2008 level

Current real rentals when adjusted for inflation are now negative. Even if the owners were to dispose of them, they will be transacted at unfavorable prices with the latest price data pointing to negative growth. Transaction volume has also slowed and that complicates exits.

Real rents are now negative

Prices are now negative yoy  

Lackadaisical transactions

And this concern is not confined to the US. In the last four months, we have had so many conversations with managers across the globe. Late last year, a manager that specialized in lending to commercial and residential developers in the German market commented that his second largest borrower which had been a client of theirs for the longest time, has defaulted on its loans. The developer cited he was unable to secure refinancing from several of his German banks because the banks have decided to pare down their exposures in real estate. This borrower is one of the largest privately held developers in Frankfurt. One of Singapore’s largest real estate conglomerates has asked for an extension of its property fund that invests in student accommodation across the US and UK after it was unable to sell off the remaining assets when the fund life ended last year. In the call, they commented that while the occupancy rate has increased, accommodation rates have not. It is also hit with a double whammy of higher operating costs and higher refinancing such that its gross property yield barely cover its interest costs. Even if there are buyers, they will be selling at 20% lower than what they paid for 5 years ago. One of the largest property fund managers and developers in the US recently defaulted on its loans for two Class A buildings in LA for a total of $784mn. We all know that Blackstone exercised the right to halt withdrawals on one of its largest property funds just several months ago. All of these are not isolated events and all of them happened even before Mar 2023 madness.  We are now expecting banks to rein in their lending further as they will be regulated even more tightly, and depositors will be scrutinizing them even more closely. Oscar Wilde once charmed “The public is wonderfully tolerant. It forgives everything except genius” and the time for the real genius to show themselves is now.

Several high-profile commercial property defaults since the start of the year

Japan has the undisputed inventor of both ZIRP (Zero Interest Rate Policy) followed by NIRP (Negative Interest Rate Policy) Bank of Japan (BOJ) is also the first central bank to embark on QE. You can trace the advent of their unorthodox policies as far back as in the late 1990s when its economy stalled after decades of runaway growth and excesses. It started with ZIRP in 1999, followed by QE in 2001, and post-GFC, they joined the other global central banks to explore the world of NIRP. Japan was deep in QE even before the lexicon was created and went mainstream! All central banks have now exited the experimental NIRP leaving Japan as the only central bank still mired in it. Japan is now the only remaining negative-yielding debt stock in the world with a total size of $1.56trn with the Bank of Japan holding close to 50% of its bonds. However, inflation is now running twice the BOJ’s target level, it is time to call on the curtains of this long experiment. What does the end of this inter-connected “life” mean for its economy and the rest of the world? We have already seen the pernicious first and second-order effects of Fed, BOE, and ECB tightening, but BOJ will be engineering the mother of all tightening sometime between now till 2024. The market consensus is calling for BOJ to widen its yield curve control by +/-100bps in the next few meetings with a shift towards guiding the front-end of the treasury curve, followed by the abandoning NIRP sometime in 2024.

Japan started NIRP and now is the only country left in the yoyo land of negative -yielding debt 

But the time to leave NIRP is now as inflation has overshot BOJ’s target

The most likely sequence of Japan’s monetary policy normalization

Source: Nomura

We attempt to analyse the ramifications of this exit and we stress the operative word is “attempt” as we can only identify possible spillover effects while acknowledging there are many hidden risks our feeble mind has yet to identify. We start by categorizing the domestic impact of the BOJ shift in monetary policy.  On the fiscal side, as Japanese Government Bonds (JGBs) yield increases, debt prepayment burden will also increase. This will have a negative impact to contributions from BOJ to the Ministry of Finance, therefore, curtailing future fiscal programs especially now that Japan is embarking on an expensive military upgrade to the tune of at least $55bn a year. Japan could face similar risk to the British Guilt crisis in November last year when leveraged accounts have to dump Guilt bonds aggressively forcing yield even higher and necessitating the central bank to back-pedal it’s plan of quantitative tightening. It has to be careful not to impede the functionality of the JGBs market as any sharp and quick jump in yields will result in substantial unrealized losses for BOJ and the financial institutions; similar to what we have seen in the UK and in Silicon Valley Bank, Down in the valley to pray. The saving grace is that BOJ and Japanese financial institutions are the only holders of JGBs therefore limiting any international fallout. On the impact on the economy, the Yen will rise which will hurt its export engine but will support domestic consumption.

BOJ is the largest holder and only buyer of JGBs      

Yen is cheap relative to USD

As for the domestic equity market, the path of returns is more complex than the above possible outcomes. Higher inflation allows corporate profits to increase as they can pass through rising costs to consumers. Historically, TOPIX valuation has risen when yield rises but at the same time, we know Japanese equities tend to underperform when the Yen strengthens. This is further complicated by the BOJ’s QE program where it holds Yen38 trn of stocks and ETFs or 10% of the entire market capitalization of TOPIX.

End of deflation is good for valuation multiples

But a strong Yen has historically been bad for equities

However, it is the international ramifications of BOJ exiting NIRP that worry us the most. Japan is the largest holder of US Treasuries worth US1.08 trn (>4% of total stock of US Treasury). It is also a significant investor in other markets controlling 15% of the Australia debt stock, 13% of Sweden, 10% of New Zealand and 8% of France. On a hedged basis, the 10-year JGB is now yielding more than the yield of US high-grade debt. Rising domestic yield and a higher cost of hedging have since triggered flight back to domestic bond market with them selling a record volume of foreign bonds in 2022. Japanese companies are also the leading FDI investors globally accounting for 25% of the global cross-border credit. Would they start pulling back on their overseas investments now that the carry trade of borrowing cheap Yen to invest in the overseas project is diminishing? The obvious outcomes from the above observations are the repatriation of Yen back by domestic investors back to the domestic capital markets and the subsequent unwinding of the biggest and longest carry-trade of all time. Think Softbank. The less obvious is the pace of withdrawal; will it be a tsunami or a stream? Ueda-San has his work cut out for him!

Japan is a colossal player in the global debt market

JGB yield > US HG hedged Yield

Leading to Mr and Ms Watanabe coming home

Asset Allocation Strategy

There is a plethora of assumptions and decisions that an investor must make. Will central bankers continue the path of tightening at the expense of financial stability? Can they assume central bankers have enacted enough stabilizers to prevent another bank run? How deep will lending be reined in as the fight for deposits and tougher regulatory scrutiny kicks in? Or perhaps growth will defy forecasts as it has in the last quarter leading back to the question of whether inflation could increase further. What about these two stress points mentioned above? Collectively they are larger than crypto market, the combined assets of SVB, SNB, and Credit Suisse and even the peak of the sub-prime debt.

We judged the first risk to be more imminent than the second, though the second risk is far more grievous and has longer tentacles in its global reach. We have seen reports that the first-order impact of banks reining in their lending will shave 0.5% to 1.0% of GDP for the US which would tilt the economy into recession in 2H2023 – 2024. We have seen reports that estimate the commercial real estate exposure losses could inflict $38bn and $16bn on the banking and insurance sectors respectively. And is not a small amount as it adds up to 4.5% of the Tier 1 Capital of the big 4 banks.

Fixed Income (Overweight in US Treasuries): There is no change in this view. Maintaining the highest quality of debt instruments is paramount. The only change we made last quarter is to increase our exposure to the front end of the US treasury curve as we are expecting the yield curve to bull steepen. We remain overweight investment grade bonds given it historically have lower default rates, higher recovery rate and the current OAS spread is already pricing some recession risk. The pain trade for last quarter is our exposure to the fund manager that specializes in hybrid capital of financial institutions. We view the decision to override the payment waterfall by the Swiss National Bank as an outliner. Since then, many central banks from BOE, ECB, BOC, HKMA and MAS have issued statements that AT1 bonds are an important part of a bank’s capital structure, and they will honor the terms of having equity shareholders write down first before bondholders in the event of a bankruptcy. This asset class now yields more than 12% and trades at a spread of 900+bps, close to the widest it ever trade at 1000bps during Covid. The historical range has been 400bps. If the portfolio is constructed with high quality names, over the next 12 months we could get an expected return of 12% yield + 200bps spread compression.

European banks have in excess of profit  even before dividends and AT1s are paid and capital key are triggered

Equities: In our last Navigator, The Indomitable Human Spirit , we have expressed the view that we will be angling to reverse our long-standing underweight in Equities to overweight in the coming months. However, the investment case has become more confusing. On one end, recent developments should precipitate a Fed pause soon and perhaps even cutting rates before the year end, but on the other with credit conditions tightening and the risk of commercial real estate imploding, the economic outlook and earnings and valuation parameters are likely to deteriorate. Having said that the equities market has been remarkably resilient despite a series of shocking internals. The broader market is higher in March Madness and selling has been concentrated in areas where the market is pricing future duress ie the banks, insurers, real estate and REITs.  We are retaining our underweight with key expressions in long/short equities managers, a tilt towards the dividend theme. We have also rebuild our tech exposure in the last quarter. We remain overweight only in Japan and Asia.

Alternatives: No changes in this sleeve. Our trade finance, Asia and quant long/short equities, and volatility strategy performed well in 1Q23 with positive performances but more importantly kept their volatility stats intact. CTA and hedge fund replication strategies were whipsawed by their short interest rates (2yrs Treasury had a 91st percentile volatility in 1Q23!), long dollar, and short energy trades and therefore were down for the quarter.

FX: For the next quarter, we expect the US dollar to weaken.  The reversal of US growth exceptionalism versus the rest of the world and the narrowing of interest rate differential. The Fed is near it pausing cycle but the ECB has just commenced its cycle and the BOJ is likely to pivot in 2Q23. Our favourite expression is to Long Yen. The risk of this view remains the escalation of geopolitics risk and the classic USD hegemony should the global economy sink into recession even if the source of stress is coming from the US itself.

Commodities: Remain bullish on oil. The prompt spread as well as the 1 year forward spread have turned bullish. As we mentioned in last publication, these have been very good leading indicators of an inflexion point in crude price. Even with the recent spike in oil price, speculative position on oil futures remains at level last seen when oil price collapse from $100 to $40 in 2014-2016. 

1 year spread has crossed the magic $4.50

Yet specs on oil is near 2015 lows

Cash: Cash holdings stays at 10-15% and we will be quick to raise cash if our worst case scenario become a base-case.

Featured Picture/Quote:

Don’t take my word. I am a nobody. Read what Joseph’s dog is saying about the Fed.

US inflation, Fed interest rates, high costs, dubious benefits. Joseph E. Stiglitz


Edward Lim, CFA

Chief Investment Officer

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