Bank for International Settlements: Global Risk ON Financed by Record Leveraged Carry Trades and Margin Debt as Balance Sheets Deteriorate, Parabolic PSEi!

In their Quarterly Review (September 2017) released yesterday, the Bank for International Settlements (BIS) or the central bank of central banks described the latest global RISK ON phase

Excerpted from the BIS: (bold and underline mine)

A “risk-on” phase

As is typical for periods of low volatility and a falling dollar, a “risk-on” phase prevailed.

Against the backdrop of persistent interest rate differentials and a depreciating dollar,returns from carry trades rose sharply and EME equity and bond funds saw large inflowsduring the period under review (Graph 7, first panel). Speculative positions also pointed topatterns of broader carry trade activity: large net short positions in funding currencies, such as the yen and Swiss franc, and large net long positions in EME currencies and the Australian dollar (Graph 4, right-hand panel).

Equity market investors also employed record amounts of margin debt to lever up their investments. In fact, margin debt outstanding was substantially higher than during the dotcom boom and around 10% higher than its previous peak in 2015 (Graph 7, second panel).

 

While margin debt levels breached new records, traditional valuation benchmarks, such as long-run average price/earnings (P/E) ratios, indicated that equity valuations might be stretched. Recent market moves pushed cyclically adjusted P/E ratios for the US market further above long-run averages. Cyclically adjusted P/E ratios also exceeded this benchmark for Europe and for EMEs, though by a smaller amount (Graph 7, third panel). That said, given the unusually low bond yields, valuations may not be out of line when viewed through the lens of dividend discount models. Indeed, estimates of bond yield term premia remained unusually compressed, well below historical averages in the United States and drifting further into negative territory in the euro area (Graph 7, fourth panel). This suggests that equity markets continue to be vulnerable to the risk of a snapback in bond markets, should term premia return to more normal levels.

There were also some signs of search for yield in debt markets, as issuance volumes of leveraged loans and high-yield bonds rose while covenant standards eased. The global volume of outstanding leveraged loans, as recorded by S&P Global Market Intelligence, reached new highs (above $1 trillion). At the same time, the share of issues with covenant-lite features increased to nearly 75% from 65% a year earlier (Graph 8, left-hand panel). Covenant-lite loans place few to no restrictions on the borrowers’ actions and as such might signal a less discriminating attitude on the part of lenders while potentially fostering excessive risk-taking on the part of borrowers. According to Moody’s, the covenant-lite share in the high-yield bond market also increased while covenant quality declined to the lowest levels since Moody’s started to record these numbers in 2011.

While corporate credit spreads were tightening, the health of corporate balance sheets deteriorated. Leverage of non-financial corporates in the United States, the United Kingdom and, to a lesser extent, Europe has increased continuously in the last few years (Graph 8, first panel). Even accounting for the large cash balances outstanding, leverage conditions in the United States are the highest since the beginning of the millennium and similar to those of the early 1990s, when corporate debt ratios reflected the legacy of the leveraged buyout boom of the late 1980s. Anddespite ultra-low interest rates, the interest coverage ratio has declined significantly. While the aggregate interest coverage ratio remained well above three, a growing share of firms face interest expenses exceeding earnings before interest and taxes – so-called “zombie” firms(Graph 8, third panel).4 The share of such firms has risen especially sharply in the euro area and the United Kingdom. At the same time, the distribution of ratings has worsened (Graph 8, fourth panel). The share of investment grade companies has decreased by 10 percentage points in the United States, 20 in the euro area and 30 in the United Kingdom from 2000 to 2017. 5 The relative number of companies rated A or better has fallen especially sharply, while the share of worst rated (C or lower) companies has increased. Taken together, this suggests that, in the event of a slowdown or an upward adjustment in interest rates, high debt service payments and default risk could pose challenges to corporates, and thereby create headwinds for GDP growth.

Based on the BIS’s description, the Risk-ON climate can be summarized as record yield chasing asset boom financed by surging leverage as balance sheets deteriorates

Rings a bell?

Oh, the BSP’s free money has sparked a bacchanalian orgy at the PSE!

The Asia's most expensive stock market has just become even more offensively expensive!