I found Carmen Reinhardt’s most recent piece in Project Syndicate thought-provoking. In it she makes a number of interesting points. First, that the spread between yields in the emerging market asset class and high-yield U. S. corporate debt is the highest in history:
Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts.
What’s driving this divergence? Are financial markets overestimating the risks in EM fixed income (EM yields are “too highâ€)? Or are they underestimating risks in lower-grade US corporates (USEM yields are too low)?
Taking together the current trends and cycles in global factors (US interest rates, the US dollar’s strength, and world commodity prices) plus a variety of adverse country-specific economic and political developments that have recently plagued some of the larger EMs, I am inclined to the second interpretation.
The second is that a considerable volume of these U. S. corporate instruments are collateralized loan obligations:
In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world. According to the Securities Industry and Financial Markets Association, new issues of “conventional†high-yield corporate bonds peaked in 2017 and are off significantly this year (about 35% through November). New issuance activity has shifted to the CLO market, where the amounts outstanding have soared, hitting new peaks almost daily. The S&P/LSTA US Leveraged Loan 100 Index shows an increase of about 70% in early December from its 2012 lows (see Figure 2), with issuance hitting record highs in 2018. In the language of emerging markets, the USEM is attracting large capital inflows.
It should be needless to say that this is terrible news for emerging economies and what is terrible news for emerging economies has a way of provoking real world events. It may not be pretty to see.
I have made no secret of the fact that I am suspicious of, as she puts it, a world economy “geared toward increasing the supply of ï¬nancial assets” without also expanding real production or even at its expense. I have explained why previously. Such an economy presents no problems as long as it does not impinge on the real world but it inevitably does.
Several issues are conflated here.
Criticism of CLOs per se is misplaced. Packaging loans provides diversification, an unalloyed good, and the slicing and dicing of the cash flows allows investors to tailor their risk tolerance. (A point I made about CMOS way back when and some couldn’t get through their heads. In fact, some tranches of CMOS were AAA rated, some junk, by design. Sending ratings agencies willy nilly to the gulag was just for pop commentators)
I think the observation about leverage underlying those repackaging events may warrant consideration. There is no law, as in physics, that says what the right amount of leverage is. It is judgement, based upon historical norms and experience, and a view of future prospects. With the Fed clearly in the middle of making a mistake, as they seem genetically destined to always do, I’d be careful with risky loans.
As for the point in the last paragraph, that’s just a variant of leverage. From a risk tolerant investor point of view, you can make a higher return in equity investments (plant and equipment, aka operating assets) than in financial assets. That’s what I do. But the opportunities must present themselves or be created. From grandmas point of view, predominantly lower, fixed income instruments make sense. Like Treasuries or high grade corporates. In between resides the appetite of the rest, be it public equities, high yield bonds, or governments.
I don’t know the correct answer for every investor. That’s their call. And I don’t know the right level of investment in operating assets vs financial assets. (And after all, an awful lot of those, if you look through, go to operating asset investment. You can’t argue against loans and investment in operating assets as if mutually exclusive). I do know meddling in the capital markets by economists, especially powerful Fed economists, is the kiss of death. And I do know that public policy should encourage investment in operating assets, not exactly encouraged in a “you didn’t do that†/ thanks for taking the risk, now give me my tribute mentality for awhile.