Developed Countries

While the Fed remains committed to ZIRP for the remainder of the year, already FOMC members started talking about talking about tapering. The next logical step is for tapering to become reality as the year draws to a close or early in 2022. Peering above the 49th parallel, the BoC yesterday opted to taper bond purchases, albeit slightly, and may offer a glimpse of what may also take root in the US in the not too distant future. True, tapering is a good thing as the Central Bank’s (CB) confidence is high that the economy is on a solid footing and no longer needs additional CB support, however if history is an accurate guide, equity investors will have to digest the tapering news once it becomes reality. The chart shows G4 CB liquidity as a 26-week change in the asset side of the balance sheet, and given that some of this excess liquidity seeps over to the US equity market, its withdrawal will likely prove tumultuous. Bottom Line: Near-term caution is warranted on the prospects of the broad equity market that remains fully valued. Please see the next US equity sector Insight.

Special Report

Highlights EM banks will underperform their DM peers in the next six months due to worsening relative NPL dynamics and shrinking net interest margins. EM banks will either continue experiencing rising NPLs and moribund loan demand due to restrictive lending rates or will have to reduce their lending rates, which will considerably shrink their net interest margins. In both scenarios, EM bank profits will be damaged. Besides, EM is facing an unfriendly macro cocktail of booming US growth and a slowing China. This could cause a capital exodus from EM in the coming months depressing EM currencies and precluding many central banks from cutting interest rates proactively. Feature Chart 1EM vs. DM Banks: More Underperformance Ahead We recommend initiating the short EM banks / long DM banks strategy. There has been a major technical breakdown in EM share prices versus DM peers (Chart 1). When discussing EM banks for the purpose of macro analysis, we separate Chinese, Korean and Taiwanese banks from their EM peers. The basis is that the banking systems in China, Korea and Taiwan1 face different cyclical and structural outlooks than in the rest of EM. Bank assets-to-GDP ratios are much more elevated and the monetary and fiscal policies have more flexibility in China, Korea and Taiwan than in EM. Chart 2Fiscal Thrust In EM And DM Reason #1: Higher NPLs In EM Than DM As a result of the pandemic lockdowns, bank NPLs have surged both in EM and DM. However, DM banks have begun to pare down the NPL provisions they had built over the past year. By contrast, NPLs in EM economies will linger due to persisting economic weakness. In fact, EM banks might need to boost their NPL provisions, further eroding their profits. DM policymakers have provided much more fiscal support to their economies than the governments in EM (ex-China, Korea and Taiwan). The fiscal thrust in these EM economies will be negative in 2021 while it is expected to be positive in the US and neutral in the euro area (Chart 2). Chart 3 shows the fiscal thrust across individual EM economies. The fiscal thrusts in Russia and Brazil are the most negative. In EM (ex-China, Korea, Taiwan), the prime lending rates have declined but are still high both in nominal terms (around 10%) and in real terms (6.5%) (Chart 4, top and middle panels). In our opinion, these levels of prime lending rates are restrictive for EM economies and will both inhibit loan demand and undermine debtors’ ability to service debt. Consistently, bank loan growth remains very muted in EM (ex-China, Korea, Taiwan) (Chart 4, bottom panel). Chart 32021 Fiscal Thrust In Individual EM Countries The pandemic is lingering in several developing countries and their vaccination efforts are trailing those of DM. Consequently, the pace and timing of a full economic recovery in EM will lag those in DM. Chart 5 illustrates that retail sales and auto purchases in EM (ex-China, Korea, Taiwan) remain lackluster. Chart 4EM Bank Lending Rates Are Restrictive Chart 5EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster   Reason #2: Net Interest Margin Squeeze For EM Banks EM banks are facing a dilemma. They have a choice between: continuing to experience rising NPLs and moribund loan demand due to restrictive lending rates, which will also undermine bank profits; and/or significantly reducing their lending rates to spur new lending and to help debtors service their loans. In such a case, their net interest margins and profits will shrink. In a nutshell, the fact that borrowers are struggling despite lending rates being much lower than they have been in the past boils down to underlying productivity and return on capital. Both have downshifted considerably in EM (ex-China, Korea, Taiwan) economies. This was true before the pandemic erupted and is also true at present. Chart 6EM Banks: Net Interest Margin And EPS In brief, the only way for EM banks to avoid escalating NPLs is to reduce lending rates. Yet, the latter will erode their net interest margins and depress their profits. Chart 6 demonstrates that net interest rate margins have been an important driver of banks’ EPS growth and they currently point to weaker bank earnings. Notably, there is little room for EM (ex-China, Korea, Taiwan) central banks to cut their policy/short rates. Doing so could trigger a weakness in their currencies at a time when US growth is booming, and US bond yields are under upward pressure. Overall, any decline in prime lending rates will produce a net interest margin squeeze for banks in EM (ex-China, Korea, Taiwan). In China, authorities have been clear that they expect banks to reduce their lending rates for SMEs even though the central bank does not plan on cutting short-term rates. Such pressure on mainland banks will intensify as growth slows in H2 2021. Hence, Chinese banks are also experiencing a net interest margin contraction. Reason #3: An Unfriendly Macro Cocktail For EM Our major global theme for 2021 is an economic boom in the US and a slowdown in China. Such a global macro dynamic warrants a rebound in the US dollar and a pullback in commodities prices. The US economy will be booming in H2 2021 facilitated by the general reopening of the economy, massive fiscal stimulus, rising employment and income growth as well as the release of pent-up demand for services. The Chinese economy is about to decelerate, as foretold by the rollover in money and credit impulses (Chart 7). China’s slowdown will lead to a decline in commodities prices and EM currencies (Chart 8). Chart 7China Is Set To Slow Down Chart 8Commodities And EM Currencies Are At Risk   Finally, one of the best leading indicators for EM EPS has been China’s narrow money growth. Chart 9 demonstrates that the latest rollover in Chinese narrow money growth heralds a slowdown in EM EPS later this year. Chart 9China's Narrow Money Heralds EM EPS Slowdown In H2 EM’s business cycle is very sensitive to China’s growth because many emerging economies sell to China as much if not more than to the US. An impending slowdown in China will cause a meaningful setback in commodities prices and will depress terms of trade for many EM (ex-China, Korea, Taiwan) economies. In turn, a booming US economy will herald higher US bond yields. Together, these dynamics will likely precipitate a rebound in the US dollar. In sum, such a macro cocktail could cause a capital exodus from EM in the coming months, depressing EM currencies and precluding many central banks from cutting interest rates proactively. As a result, EM local currency bond yields will not fall much, especially in vulnerable EM countries. Chart 10EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise Chart 10 demonstrates that the rise in EM local currency yields (shown inverted on the chart) is typically negative for EM (ex-China, Korea, Taiwan) bank stocks. This is opposite to the dynamics in the US and in Europe where bank share prices rally when bond yields rise. Reason #4: Chinese Bank Stocks Remain A Value Trap Market cap of Chinese bank stocks represents 25% of the MSCI EM bank index. Hence, the performance of Chinese bank share prices contributes significantly to the MSCI EM bank stock index. Chinese commercial banks’ assets have expanded 1.5-fold since early 2009 (Chart 11). The overwhelming part of this expansion has been driven by loan origination, purchases of corporate bonds and various claims on local governments and their affiliated vehicles.  We have written often and at length that there is no link between trends in bank assets and national or household savings. Critically, banks do not intermediate deposits into loans or savings into credit. This holds true in all countries around the world. Following such an epic credit boom in China since 2009, one would typically expect creditors in general and banks in particular to undertake a profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, Chinese banks have not yet sufficiently cleansed their balance sheets and carry a lot of non-recognized bad loans/assets. Investors doubt the quality of the banks’ books. As a result, Chinese banks’ share prices have been in limbo over the last ten years (Chart 12, top panel). Chart 11Chinese Bank Assets: An Epic Boom Chart 12Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan   Provided that this issue of mainland bank asset quality is well known, the government will not allow a full-fledged banking crisis. However, authorities will also not recapitalize banks without current shareholders experiencing losses. Overall, Chinese bank share prices might share the fate of Japanese bank stocks. The latter has been in a secular bear market even though Japan has never had an acute credit crisis (Chart 12, second panel). In a nutshell, Korean and Taiwanese bank share prices have also delivered very poor returns over the past 20 years, even though these banks have not had an acute crisis and the credit-to-GDP ratios in these economies have been rising (Chart 12, third and fourth panels). The upshot is that a rising credit penetration is not sufficient to produce value for bank shareholders. The quality of credit assets, profit margins and the starting points of both equity valuation and bank capital adequacy matter for forward returns on bank stocks. A Word On Bank Stock Valuations Chart 13EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio Even though Chinese bank stocks trade at very low multiples – the price-to-book value (PBV) ratio is presently 0.6, the latter represents a value trap. For comparison, the PBV ratio is 0.5 in Korea and 1.2 in Taiwan. Excluding China, Korea and Taiwan, the EM bank PBV ratio is well below its historical mean (Chart 13). However, this aggregate conceals the wide disparity among EM banks. Chart 14 plots banks’ return on equity (RoE) over the past 12 months on the X-axis and their PBV ratio on the Y-axis. There is a clear positive correlation between RoE and the PBV ratio.   Chart 14A Comparative Valuation Matrix For Global Bank Stocks Combining bank equity valuations and country macro fundamentals, within the EM bank space we favor banks in India, Mexico, Korea, the Czech Republic, Russia (barring a major military conflict in Ukraine) and Singapore. On the other hand, the most vulnerable are bank share prices in Brazil, Peru, Turkey, the Philippines, Malaysia and Indonesia. Concerning Chinese banks, we continue advocating the long large banks/short small and medium bank stocks strategy. The rationale is that a lot of bad news is already discounted in large bank stocks and little in listed small and medium bank stocks. In particular, the PBV ratio is 0.7 for large banks and 1.3 for small and medium banks. More so than large banks, small and medium banks are at risk from the new asset management regulation that will be implemented by the end of this year. Investment Recommendations We initiate a short EM banks / long DM banks position. This is a medium-term strategy for the next six months. This strategy is consistent with our tactical underweight in EM stocks versus DM stocks that we recommended on March 25. From a structural perspective, we continue recommending a neutral allocation to EM within a global equity portfolio. Today we are also publishing a report on India that highlights near-term downside risks to this bourse due to surging COVID-19 cases. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential super-spreader events. As a result, we recommend that asset allocators with less tolerance for volatility tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Chart 15Move Peruvian Stocks From Neutral To Underweight Finally, Peruvian bank stocks have been plunging on the heels of left-wing candidate Pedro Castillo lead in the presidential electionspolls ahead of the second round on June 6th. Chart 15 shows that surging NPLs (shown inverted) herald more downside in bank share prices. Consequently, in the context of political uncertainty, rising NPLs and a potential decline in metal prices, we are downgrading Peruvian equities from neutral to underweight. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 We refer to Taiwan (Province of China) herein in the report as Taiwan.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Investors’ hunt for yield over the past few years led them to view leveraged loans as an attractive investment. Characterized by low volatility and attractive risk-adjusted returns, leveraged loans can add value to a portfolio. Leveraged loans tend to outperform their fixed-rate counterparts (for example, high-yield bonds) in an environment of rising rates and an attractive valuation starting point. Only the former criterion is true currently. Risks do exist, however. The increasing share of covenant-lite issues, and rising leverage in the corporate sector are of particular concern. Over the next 6-to-12 months, we do not expect rates to rise substantially, making the asset class somewhat unappealing in the short term. The longer-term outlook is attractive nevertheless, since rates are likely to rise as inflation picks up over the coming years. Feature In today’s environment of ultra-accommodative monetary policy, including low interest rates, and unattractive valuations for fixed-income risk assets, investors have no option but to look beyond conventional fixed-income instruments and dial up their risk appetite. In this Special Report, we run through the mechanics of the leveraged loan market. We analyze historical risk-return characteristics and compare leveraged loans to other assets. We also assess their performance during periods of financial-market stress as well as periods of rising rates and inflation. Finally, we discuss the risks associated with owning leveraged loans. What Are Leveraged Loans? Leveraged loans are a type of syndicated loan made to sub-investment-grade companies. Generally, these firms are highly indebted, with low credit ratings. A syndicated loan is structured, arranged, and administered by one or several commercial or investment banks.1 The majority of these loans are senior secured loans and are based on a floating rate, mostly LIBOR plus a premium (more than 150-200 bps) to account for their riskiness as well as to attract non-bank institutional investors. The interest rates on these loans adjust at regular intervals to reflect changes in short-term interest rates; this constitutes a benefit for investors worried about rising rates. Definitions vary when it comes to categorizing leveraged loans. Some group them based on the borrower’s riskiness and their credit rating. Others consider leverage metrics such as debt-to-capital and debt-to-EBITDA. Other classifications look at the spread at issuance or the purpose of the fund raising, which can include funding mergers and acquisitions (M&A), leveraged buyouts (LBOs), refinancing existing debt, or general funding. Over the past five years, approximately 50% of US leveraged loans issued were for refinancing purposes (Chart 1, panel 1). Within the three categories, LBO financing is deemed the riskiest, and this is reflected in its higher spread (Chart 1, panel 2). The leveraged-loan market became particularly popular in the mid-1980s as M&A activity was soaring (Chart 2). Chart 1Uses Of Leveraged Loans Chart 2The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth There are two common types of financing facilities:2 Term loans: An agreement to borrow a sum of money that is paid back over a certain payment schedule. These loans are mainly provided by non-bank entities. Revolving facilities: A type of loan that can be repeatedly drawn upon and repaid. These loans are mostly originated and held by banks. Estimates for the size of the leveraged-loan market vary depending on which criteria and definitions are used. The size of the leveraged-loan market, following rapid growth since the beginning of the past decade, is estimated to be over $1.2 trillion as of Q2 2020.3 While this represents only a small portion of overall corporate debt (it is only 15% the size of the corporate bond market), the interconnections between key market participants and the role of banks in the market has caught the attention of several regulators such as US Treasury Secretary Janet Yellen, debt investors such as Howard Marks, and international institutions such as the Bank For International Settlements (BIS). The focus of their concerns has been on the declining credit standards for leveraged loans – particularly, the increase in issuance of “covenant-lite” (cov-lite) loans, inconsistent definitions of EBITDA in loan agreements, the growth in use of “EBITDA add backs”,4 and the accuracy of leveraged-loan ratings.5 We discuss some of those concerns in the Risks section. Table 1Risky Loans Are Mainly Held By Non-Bank Entities… Over the past several decades, the role of banks in providing capital to the leveraged loan market has shrunk and has been replaced by non-bank lenders such as mutual funds, hedge funds, insurance companies, and asset managers.6 Data by the Shared National Credit (SNC) program7 shows that non-bank entities in the US now hold close to 83% of all non-investment-grade term loans (Table 1). Moreover, estimates by the Bank of England8 (BoE) show that a quarter of the global stock of leveraged loans (which it estimates at close to $3.4 trillion) is held through collateralized loan obligations (CLOs)9 and approximately half is owned by non-bank institutions. In turn, those non-bank institutions hold a significant portion of CLOs – particularly the riskier tranches. This is not to say that banks are not exposed to leveraged loans. But banks predominantly invest in the highest, AAA, tranche of CLOs, and investment-grade loans.10 Riskier-rated loans are held by CLOs, mutual funds, and other lenders such as hedge funds (Chart 3).11 Chart 3…Particularly Those Rated Below BB Historical Risk And Return Chart 4Leveraged Loans' Relative Performance Moves With Interest Rates Since 1997, leveraged loans12 have returned an annualized 4.9%, 25 basis points higher than US Treasurys and approximately 100 and 200 basis points less than US investment-grade and high-yield bonds, respectively. They have underperformed US equities by an annualized 400 basis points over the same period. Declining rates over the past two decades are the most likely reason leveraged loans have underperformed their fixed-rate counterparts. The relative performance of leveraged loans to investment-grade bonds has closely tracked the trajectory of Treasury yields (Chart 4). While the case is not as clear for relative performance against high-yield bonds, the trend is similar. However, on a risk-adjusted return basis, due to reduced volatility, leveraged loans did outperform both equities and high-yield corporate bonds (Table 2). We nevertheless think that volatility is likely understated given the elevated kurtosis. The larger negative skew and excess kurtosis could indicate higher probabilities of large negative returns (Chart 5).   Table 2Historical Risk-Return Characteristics Chart 5Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Why Should Investors Consider Leveraged Loans? Chart 6Rising Rates Support Higher Return From Leveraged Loans... Our US bond strategists have showed that the odds of leveraged loans outperforming fixed-rate high-yield bonds increase when certain criteria are in place – particularly when valuations are tilted in loans’ favor, and Treasury yields are rising.13 Only the latter criterion is true currently. Year-to-date, leveraged loans have returned 2.2%, higher than the -3.2%, -3.4%, 1.6%, and -3.4% from US Treasurys, investment-grade bonds, high-yield bonds, and emerging markets sovereign debt, respectively (Chart 6). During the same period, Treasury yields rose by 65 basis points. We find that periods of rising Treasury yields are associated with increased flows into the asset class (Chart 7). More interestingly, leveraged loans outperform junk bonds when Treasury yields rise faster than what is discounted in the forwards curve over the following 12 months (Chart 8). Chart 7...As Well As Increased Fund Flows Chart 8Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve     This does not seem to be the case today, however, with the 5-year, 1-year forward about 40 basis points higher than the current 5-year Treasury yield. This is in line with our view that rates are unlikely to rise substantially over the next 6-to-12 months. Inflation, beyond a temporary spike over the next few months, should remain subdued, at least until employment is back to a level which would put upward pressure on wages. This is unlikely before 2023. It is also important to consider the potential trajectory of monetary policy as well as changes in long-term yields. The Fed, through its dot plot, is signaling no increase in the Fed Funds Rate before 2024, but the market is becoming worried about inflationary pressures and pricing in an earlier Fed hike. We believe it unlikely that the Fed will raise rates ahead of what the market expects, unless the labor market returns to “maximum employment” over the next 12 months. The yield on leveraged loans has been lower than on high-yield bonds for most of the period we have data for, except early 2020. Given leveraged loans’ senior position in a firm’s capital structure, it makes sense that their yields are lower. Additionally, the sector composition of the two markets plays a role: Leveraged loans are more exposed to the Technology and Communications sectors and have a limited allocation (averaging 1% over the past seven years) to the Energy sector, unlike high-yield, fixed-rate bonds (where the weight of Energy has averaged 13%) (Chart 9). This was mostly evident when the yield differential collapsed to below -3% during the 2014/2015 oil crash (Chart 10). Chart 9Leveraged Loans’ Sector Weightings Chart 10Loan Spreads Are Not Looking Attractive Chart 11Recent Investor Demand Pushed Up Leveraged Loan Prices The yield differential has, however, been trending upwards since then, and at current prices, upside may be limited. The recent surge in investor demand has pushed down yields on newly issued leveraged loans, moving the average bid price of leveraged loans above its pre-pandemic high (Chart 11). In the next section, we analyze how leveraged loans have behaved during recessions and other periods of financial market stress.   Financial Market Stress Performance In Crises Given the index’s short history, we are able to cover only the past three recessions (the dot-com bubble bust, the Global Financial Crisis (GFC), and the COVID-19 recession). We also look at the 2013 Taper Tantrum and the 2014/2015 oil price shock. In all cases, leveraged loans fell and subsequently recovered along with other fixed-income asset classes. The Taper Tantrum was the most favorable for leveraged loans: 10-year Treasury yields rose by 100 basis points over four months (Chart 12). Table 3 shows that periods of rising rates are a better environment for leveraged loans than those of declining rates. We also looked at a period of Fed tightening and easing cycles – although the timing of easing cycles overlaps with, recessions, dragging down the performance of leveraged loans. We also assess the impact of inflation on leveraged loans using the framework from our Special Report on inflation hedging,14 which decomposed inflation into four quartiles/regimes: Inflation levels below 2.3%, between 2.3% and 3.3%, between 3.3% and 4.9%, and above 4.9%. We add periods of decreasing inflation to our analysis. We note, however, that there was only one period where inflation was over the 4.9% threshold. Chart 12Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress   Table 3Leveraged Loans’ Performance During Different Rate Cycles… Table 4…And Inflation Regimes During periods in the first and second inflation quartiles, leveraged loans, in absolute terms, had the highest average annualized returns, 8.1% and 10% respectively. This makes sense since in those regimes, policy rates are low and bond yields begin to rise given robust growth. Leveraged loans, however, underperformed fixed-rate bonds during those periods. Inflation above 3.3% represents an environment in which the economy begins to overheat and growth to falter. This regime saw leveraged loans outperform high-yield bonds by an annualized 1.5%. Periods of declining inflation also showed moderately positive annualized returns for leveraged loans (Table 4).   Risks Chart 13Corporate Health Has Worsened... The growth of the leveraged loans market reflects multiple trends but, most importantly, a broad increase in corporate leverage, driven by a decline in interest rates and increasing availability of cheap financing. The debt-to-asset ratio of nonfinancial businesses, a gauge of corporate leverage, is at a 20-year high (Chart 13, panel 1). This raises concerns about the overall health of the corporate sector – particularly firms’ ability to service their debt – since the median interest coverage ratio is near a level last seen during the GFC. This measure is even negative for companies within the 25th percentile, meaning companies in that bucket lack funds to maintain their interest payments (Chart 13, panel 2). Trends in the leveraged loan market paint a similar picture. The share of newly issued loans by the most highly levered firms – those with a debt-to-EBITDA ratio of 6x or higher – has reached new highs, hitting 37% of new loans in Q3 2020 (Chart 14). Chart 14…Even For Leveraged Lending Chart 15Cov-Lite Issuances Make Up Almost 80% Of New Issuances The providers of capital are partly to blame. Even with credit standards deteriorating, firms looking for capital were mostly able to find it. The share of cov-lite structures – loans that lack the protective covenants found in traditional loans – continues to grow and now comprises almost 80% of new issuance (Chart 15). Cov-lite loans typically do not have any maintenance covenants, requirements to maintain certain ratios such as leverage or interest-coverage ratios.15 Instead, they feature incurrence covenants which have to be met only if the issuer wants to take particular actions, such as taking on more debt.16 This loosening of credit terms is mostly a function of increased demand, particularly by CLO buyers and other non-bank institutional investors, in an environment of low yields. Some have even warned that vulnerabilities in the leveraged-loan market could cause disturbance to the overall financial system. Particularly, memories of the GFC and worries about the “originate-to-distribute” model – whereby banks originate loans but retain only a fraction on their balance sheets – have led some observers to suggest this could all lead to a risky expansion of credit, and trigger a new financial crisis. Chart 16Leveraged Loans Have Higher Average Credit Ratings… We do not share this skepticism. Banks’ exposure to leveraged loans is mainly via the highest tranches of CLOs. Banks’ liquidity requirements have increased since the GFC, and therefore contagion should be minimal in the event of problems in the loan market. A recent report by the US Government Accountability Office (GAO) did not find evidence that leveraged lending presented a significant threat to financial stability.17 Additionally, almost all leveraged loans are first lien, they have a senior secured position in the capital structure, higher average credit ratings than high-yield bonds (Chart 16), and lower default rates (Chart 17). Moreover, their five-year average recovery rate of 63% tops the 40% of senior unsecured bonds (Chart 18). Chart 17...Lower Default Rates... Chart 18...And Higher Recovery Rates Than High-Yield Bonds   Conclusion In a period of ultra-low interest rates and stretched valuations for risk assets, leveraged loans have emerged as an interesting asset class for investors. Due to lower volatility, leveraged loans have historically produced higher risk-adjusted returns than fixed-rate high-yield bonds. However, volatility is likely understated given elevated levels of kurtosis. Historically, rising Treasury yields and an attractive valuation starting-point provided a signal for leveraged loans’ outperformance. Only one of those two criteria are currently in place. In the next 6-to-12 months, we do not believe rates will rise substantially, making this asset class somewhat unattractive in the short term. The longer-run outlook for leveraged loans, however, is attractive. As inflation, and therefore rates, rise over the next two-to-three years, a moderate allocation to leveraged loans might be a useful hedge for investors.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1 Please see “LCD Loan Primer – Syndicated Loans: The Market and the Mechanics,” S&P Global Market Intelligence. 2 Please see “Leverage Lending FAQ & Fact Sheet,” SIFMA, February 2019. 3 Please see “Federal Reserve Financial Stability Report,” November 2020. 4 “EBITDA add backs” add back expenses and cost savings to earnings and could inflate the projected capacity of the borrowers to repay their loans. 5 Please see Todd Vermilyea, “Perspectives On Leveraged Lending,” The Loan Syndications and Trading Association 23rd Annual Conference, New York, October 24, 2018. 6 Please see “Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, Chapter 1,” IMF, April 2019. 7 The SNC Program is an interagency program designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions. The SNC Program is governed by an interagency agreement among the three federal bank regulatory agencies - the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office Of the Comptroller Of The Currency (OCC). 8 Please see “Financial Stability Report,” Bank of England, August 2020. 9 CLOs are asset-backed securities issued by a special purpose vehicle which acquire a portfolio of leveraged loans. 10 Please see “Turns Out Leveraged Loans Aren’t a Systemic Risk After All,” Bank Policy Institute, February 8, 2020. 11 Please see Seung Jung Lee, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, “The U.S. Syndicated Term Loan Market: Who holds what and when?”, November 25, 2019. 12 For the purpose of this report, we use the S&P/LSTA Leveraged Loan Index, which tracks the market-weighted performance of US dollar-denominated institutional leveraged loan portfolios. 13 Please see US Bond Strategy Report, “The Price Of Safety,” dated January 27, 2015. 14 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 15 Please see Eric Goodison And Margot Wagner, Paul, Weiss, Rifkind, Wharton & Garrison Llp, “Covenant-Lite Loans: Overview,” August 2019. 16 Please see Scott Essexx, Alexander Ott, Partners Group, “The Current State Of The Leveraged Loan Market: Are There Echoes Of The 2008 Subprime Market?”, March 2019. 17 Please see “Financial Stability: Agencies Have Not Found Leveraged Lending To Significantly Threaten Stability But Remain Cautious Amid Pandemic,” United States Government Accountability Office, December 2020.

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Overweight The niche S&P containers & packaging index is often flying below investors’ radars, but an upbeat global macro picture suggests that an overweight stance is warranted. These neglected materials stocks are a play on rising pricing power due to insatiable demand for containerboard and other packaging materials that the pandemic-driven boom in e-commerce has only exacerbated. Already, intermodal rail carloads that gauge the retail industry’s demand and go toe-to-toe with container and packaging manufacturers’ profits, argue for meaningful upside from current levels (middle panel). Similarly, the CASS freight index that tracks the health of different US freight industries is surging and confirms that relative profits will rebound in the back half of the year (bottom panel). Sector-level operating data are also firming. As we showed in this Monday’s Strategy Report, there is a steep divergence between containers & packaging producer prices and employment with the former outpacing the latter. The implication is that a larger fraction of revenues will reach the bottom line and push relative share prices higher. Bottom Line: We reiterate our overweight stance in the S&P containers & packaging index. The ticker symbols for the stocks in this index are: BLBG: S5CONP– WRK, SEE, IP, AVY, BLL, PKG, AMCR. ​​​​​​​