The Next Bubble in the Making?
The first half of 2018 has been one of uncertainty and volatility. Concerns over global growth, North Korea, trade wars and continued uncertainty in the Middle East have created many opportunities for short term traders. Even though opportunities have been created for short term traders, we do not believe the picture has changed for long term investors as we still remain constructive on the economy, corporate profitability and valuations. The exception to this lies not in equity markets, but rather with bonds and structured fixed income products.
A benefit of today’s low interest rates is the inexpensive source of funding available for all debtors – from governments to companies to individuals. Their costs of borrowing are quite low, so their purchasing power is great. However, as we have seen in past credit cycles, there are negatives to offset the positives. In many cases, “free money” pushes up asset prices and leads to a more speculative environment.
A great example of this can be seen in the collectible car market. On June 21st-23rd, Barret Jackson, one of the largest and most respected auctioneers in the collectible car markets, held their Northeast auction at the Mohegan Sun Casino in Connecticut. Over the three days, exotic cars like Ferraris and American Hot-rods and everything in between were auctioned. A good friend who is a self-proclaimed car nut had a group of us over to watch the auction on television (free food and beer, I was in). While watching it I was struck by the prices paid for some “regular” collectible cars. Likewise, I was surprised by some of the commercials shown during the auction.
One particular commercial showed a lending company who was offering 144 month or twelve year financing to car collectors. They promised a low down payment and waivers of past credit history. Essentially, this lender was willing to speculate on a robust collectible car market ignoring the borrower’s ability to repay the loan. From the borrower’s perspective, as long as prices keep increasing there is very little risk of selling their car for less than they paid if they ever find themselves in a position where they could no longer make their loan payment. Does this sound familiar? This is eerily reminiscent of the behavior many mortgage lenders adopted pre-financial crisis.
So who is funding this type of speculative lending – yield starved investors increasing risk in search of higher returns. I’ll delve more into this later. As we have stated many times in the past, we at Granite Investment Advisors strongly believe that the fixed income portion of any portfolio should be designed to preserve capital, not increase risk.
The Hagerty Insurance Company is one of the largest insurers of collectible cars and motorcycles. As such they have a vast database of historic prices and current values in the collectible space. They have used this pricing data to create indices of various antique car prices. One of which is their “Blue Chip” index which tracks the most sought after post-war car prices (see Exhibit 1). They created this index in September of 2006; since then the results have been quite amazing. On average, cars that sold for approximately $600,000 in September of 2006, dipped slightly after the financial crisis, but continued a steep climb thereafter. Over roughly a decade, prices have increased more than fourfold. While it’s difficult to quantify, we believe aggressive/ speculative lending played a large role in creating this bubble.
It has clearly become a sellers’ market. Therefore, our suggestion to anyone who doesn’t know what to do with their great old car is to take advantage of this sellers’ market.
This “free money” is also being used by companies for both deal and buyback purposes. Investors stretching for yields are all too happy to help. Not only are they willing to provide funding, but they are also taking more risk to do so. As can be seen in Exhibit 2, U.S. corporate debt has more than doubled since the financial crisis. Not surprising at historically low rates, debt is less costly than equity funding for most companies. However, there is a fine line after which companies become over levered. One of our basic investing tenants is to avoid over leveraged companies, analyzing each on their own merits. Consequently, we are closely watching the amount of debt being raised by companies across all sectors. Especially since we believe that during the next economic down turn over leveraged corporations will have even less flexibility than they did in the past.
The absolute levels of debt are of concern, but even more so is the riskiness of it. Cov-Lite is an industry term that refers to loans with minimal covenants. These are not bonds, but rather loans from financial institutions, banks, insurance companies and hedge funds. Covenants are restrictions or stipulations in loan agreements that are designed to protect lenders. They range from debt levels relative to the company’s income levels, restrictions of additional borrowing, total indebtedness and a whole host of other possibilities. In short, they are designed to insure that lenders get paid back. In 2007, these types of loans represented approximately 25% of the leverage loan market.
Starting in 2011, financial institutions, in a desire to show lending growth, waived many of these covenants. In other words, their new loans are inherently riskier than older loans. These loans may have higher defaults than anticipated. While this might not be an issue in an expanding economy, it could be a bad omen during the next downturn. Exhibit 3 shows the rapid rate of increase of Cov-Lite loans since 2014, settling in at nearly 80% of today’s leveraged loan market.
As with prior mortgages, it is difficult to know who owns these loans. They have likely been packaged as pooled products, and sold to yield hungry investors. At Granite Investment Advisors we choose to avoid structured products, and instead own individual bonds and ETF’s. We can better analyze these assets versus assessing each credit pool within a structured product. Again, we do not believe investors should speculate with fixed income securities, but instead use the asset class to focus on preserving capital.
Overall we remain constructive on equites and less so on bonds. As we have highlighted in the past, for the first time in recent memory the global economy is close to expanding in unison. Recent U.S. tax cuts are now flowing through the economy and corporate profitability. Interest rates, while increasing, remain somewhat constructive. We are of the belief that current trade disputes will remain just that – disputes – without leading to trade wars. Finally, valuations while not cheap are also not expensive.
Another area of concern we are monitoring is inflation through wage pressures. Some inflation actually is a positive for corporate profits. However, rapid inflation is a large negative. Most business owners/leaders will tell you that one of the biggest issues they now face is attracting high quality employees. Some claim it’s due to the Millennials’ work ethic, but this does not explain the whole labor picture. Labor shortages have led to more flexibility and higher wages for some. I witnessed this labor shortage first hand while on vacation in Upstate New York. At three different restaurants, we were told that the wait time for our meals would be an hour or more. I was surprised by this information since none of the restaurants were filled to capacity. When I inquired about the situation, each of the restaurants told me that they were short on staff and struggling to attract good employees. This issue is echoed by other business owners throughout the country, and could result in widespread wage pressures. While this issue has not materialized in overall wage growth, it is an issue we are monitoring closely.
A popular view with which we disagree strongly is that we are due for a recession in the U.S. because this economic expansion has been one of the longest in recent history. While the duration cannot be argued, we take exception to the pace of this recovery. It is not unusual to see GDP growth of 5+% one or two years after a recession. We have yet to experience strong GDP growth though. So while the duration has been long, the trajectory has been somewhat muted. While our crystal ball is as cloudy as others, we remain constructive for the foreseeable future.
At this point we see nothing disrupting the economy until 2020 and perhaps further. Certainly, we are watching the economy and the markets closely, and will adjust our view if contrary data emerges.
As always we thank you for the trust and confidence you place in us.
Scott B. Schermerhorn
Managing Partner and Chief Investment Officer
There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors' recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.