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Chris Haffenden

From hard landings to soft landings, the narrative this week shifted to another option, a no landing, as economic news once again surprised to the upside. While hard landings are obviously bad for risk assets, markets are now waking up to the risks from growth surprising to the upside. 

The vibes of August are very different than those just a few months ago.

Mentions of recession in company earnings calls dropped sharply in their second quarter releases. And investor sentiment is changing too, as BofA’s latest global fund manager survey has one-in-three not expecting the global economy to go into recession at all by December 2024, double the number from a month earlier. Those looking for a soft landing remain in the majority at 65% — although it is worth mentioning at this point that only one to five (definitions can vary widely) of the last 11 recessions ended up avoiding a hard landing. 

Proponents of the 2023/24 soft landing scenario point to the low unemployment rate — the Sahm rule states that a recession occurs when the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its low over the preceding 12 months. 

Over the last 75 years, every time the unemployment rate has moved up by half a percentage point or more, it has resulted in a full-blown recession. In March 2022 Jerome Powell noted that the soft landings in 1964, 1984 and 1993 saw unemployment staying low, despite rate rises.

Allianz in a note in late July said that US and Eurozone growth were defying gravity. Admittedly with wide divergences in the latter with France performing strongly up 0.5% (distorted by the delivery of a large cruise ship) and Germany in trouble at 0.0% (energy costs, weaker demand from China, worker shortages). Q2 Eurozone GDP returned to growth in Q2 23 up 0.2%, with a stronger 0.5% number among EU countries, with the EIU forecasting 0.8% for FY 23. 

What if the economic slowdown narrative is just negative vibes from talk of record mortgage rates, tighter credit conditions, nervous consumers etc? 

We’ve mentioned in the past in the Workout about the bullwhip effect, which states that demand distortion in the supply chain can be magnified as it travels upstream. 

As Josh Latham and Laura Thompson outline in the Great De-Stocking, a number of industries have suffered demand destruction and heavy de-stocking, most notably the chemicals industry, but also in packaging, pulp & paper, with shipping companies warning of lower volumes. 

One comment in their excellent piece might have nailed what could be happening:

“To my mind, the de-stocking reason is a farce — it’s not like the supply chain is full of inventory,” said a second buysider. “Commodity costs are falling and so customers are waiting for those costs to bottom out before they buy. Weak demand is the main thing, not de-stocking.”

This lower demand from customers might explain the divergence between purchasing manager surveys indicating a sharp recession and real economic data coming in consistently higher than expected. Could we even see a spike in growth in Q4 as the de-stocking effect wanes?

So why is a no landing (neither hard or soft) scenario negative for borrowers? 

With core inflation likely to stay above Central Bank mandate levels for the foreseeable future, the narrative that growth will slow gradually allowing room for the Fed and ECB to lower rates in the first half of 2024 may no longer apply. 

This means that rates are likely to stay much higher for much longer, causing yet more pain for those with floating exposure and potentially scuppering hopes for bond borrowers with 2025 and 2026 maturities that they could refi at better rates next year as rates come down. 

Arguably it is even worse in Europe given the ECB’s sole mandate to keep inflation to below 2%, with core inflation here proving more stubborn than across the Atlantic. 

This week Fitch issued an update on its forecasts for European Leveraged Finance, saying that it expects bond and loan default rates to rise from around 2% to 4% at year end. Its at-risk portfolio of B- credits and below (remember the agency known for often rating HY a notch higher than its peers) is 17.8% of the total number of loans. 

Rising default rates in Europe and the US should whet the appetite of global distressed funds but, as ever, timing and selection is everything, with some deploying their dry powder too early and heavily burned by the collapse of the China Real Estate sector.

Several funds bought into Chinese Property debt in the 20s and 30s way back in 2021, and will be hoping that the average recovery projected by Deloitte under Evergrande’s restructuring plan is indeed 22.5% rather than 3.4% under a liquidation. In late July, Evergrande’s wind-up hearing was adjourned until 30 October. 

But news that Country Garden, the largest Chinese developer had missed two bond payments late last week (the grace period expires on 6 September), and suspended trading in its bonds, would have sent further shock waves across the sector, in which two-thirds of private borrowers have defaulted, and 40% of total debt (by value).

Country Garden has $2bn of renmimbi debt due in the next six-months as well as a $1.9bn offshore bond. If it fails to pay the coupon under the grace period, another $10.8bn of debt will cross-default. There is a quirk, however, as defaulting on offshore debt might not trigger a cross default on the onshore debt, notes JP Morgan, which suggests the company could use this as an option to preserve cash and seek to finalise completion of part-finished properties. 

Incredibly, the developer has over 1m unfinished units. 

Morgan Stanley, in a research note, said avoiding default “is depending on additional financing support from regulators in the coming weeks, but we see chances of such help materialising becoming smaller”.

If that wasn’t bad enough, most of its sites (65%) are in third tier cities, and local authorities could grab Country Garden deposits sitting in escrow accounts to help projects complete, reducing amounts available to bondholders. 

But following Evergrande’s collapse, last year China changed local rules for forbearance, which now provide greater flexibility for restructuring processes. Amazingly, Country Garden was on China’s list of top-quality developers at this time. 

The latest events have led to concerns over contagion from the Country Garden fallout. Gavekal Research suggests unpaid bills from Chinese developers could be as much as $390bn.

Then there is growing concern over the health of the Chinese Trust industry, after Zhongzhi International Trust part of the massive conglomerate Zhongzhi Enterprise Group (reportedly has $133bn of assets) failed to repay proceeds under two of its products. 

As Bloomberg’s The Brink newsletter highlights, the $2.9tr trust industry is a key player in Chinese real estate, offering construction loans to developers, and are also investors in their equity and bonds (around $155bn). Trust company products are sold with implicit guarantees from banks, which means that financial institutions as well as shadow banks could be drawn in. 

The South China Morning Post yesterday (Thursday) reported that KPMG was brought in to conduct an audit of Zhongzhi Enterprise Group in late July. The ‘people familiar with the matter’ — which we assume are source code for company PR — said that the company plans to restructure its debt and sell assets after the review to repay investors. 

The Chinese authorities have set up a task force staffed by the banking regulator to look into Zhongzhi. After, all If investors lose confidence in the sector and seek to withdraw their funds, there could be a run on the shadow banking system. It wasn’t that long ago that the population took to the streets to protest and boycott paying their mortgages. 

So is it time to make a call for a Garden Rescue? Don’t worry, I wasn’t thinking of Charlie Dymock and her boys, this situation will require more than superficial re-landscaping and a water feature.

I’m aware that Chinese debt is not part of 9fin’s core coverage and we’ve been here before talking about potential contagion from Chinese distress spilling over into wider markets, only for the eventual impacts to end up being limited. The Bank of England is the latest to raise concerns on CRE and exposure to China and Hong Kong. 

But given the size of the opportunity for distressed funds is huge in comparison to distressed assets in other markets, save other Real Estate assets, it is worth keeping an eye on. 

After all we haven’t had a sizeable distressed situation in EEMEA which has resulted in a lot of secondary trading in debt claims, since Dubai-based NMC Healthcare in 2021/2022 when over $4bn of paper came up for sale. 

Some of the informational holes in Ideal Standard’s request to amend change-of-control provisions (to 72c from 101) were filled with the release of the full consent solicitation earlier this week. Our legal team have analysed the docs, noting there are two tiers of proposed amendments with different outcomes for each, if 90% approval is secured (or 75% then via scheme), all existing notes will exchange into this new structure, but non-consenting holders will receive a series of notes without the cash consideration or the B Preferred Units.

If >50% but <90% (or 75% then via Scheme) approval, consenting holders will exchange into New Notes with the new structure (Special Mandatory Price plus Cash Consideration, if early bird, and B Preferred Unit). Non-consenting holders will retain existing notes but be subject to a covenant and security strip and a MFN clause in the New Notes preventing stub notes from having a higher principal recovery than the consenting holders prior to maturity.

Vivion appears to be limping towards the finish line in its bond exchange offer and consent solicitation (our initial analysis is here) with 70.6% of its 2024 holders accepting by Tuesday’s deadline, short of the 75% required. The early exchange deadline was extended until yesterday (17 August) and on Weds an interesting supplement to the exchange offer was issued, tweaking some of the terms. Most notably, a most favoured nation clause was inserted, meaning that if stub note holders subsequently received better terms, the previously extended holders must be compensated. This and other tweaks such as the inclusion of a 1% redemption fee, should remove some of the game theory and the attractiveness of staying put. 

My colleagues were able to unearth more details on Wittur’s restructuring this week. KKR, the sole holder of the second lien for the German elevator components manufacturer is taking control after injecting €85m at a new HoldCo level, with the existing debt reinstated 60:40 to OpCo and HoldCo debt. The deal requires 100% approval from 1L lenders, with an English Scheme the likely alternative if a fully consensual deal cannot be reached. 

Keter announced that it had received 100% approval from lenders to its loan extension to allow time for the Israeli plastic sheds (and other storage) manufacturer to find a buyer. A shame, as a Scheme would have shed some light on what happened in negotiations between the sponsors and the lenders after several failed attempts to agree an amend-and-extend transaction. 

Victoria Plc was floored by its auditors this week, unable to publish its results as hoped, the news resulted in its bonds falling by over two-points. The UK-based flooring company has been under scrutiny in the past for its accounting treatment. On face value the numbers in their trading update look good, but are inflated by numerous acquisitions. 

On their conference call (only written questions allowed mind) they said that the delayed audit is due to routine audit procedures with six items being tested, which were valuations of goodwill, some complexity around the reverse carve-out of Balta, testing around finalising property, plant and equipment valuations, finalisation of pension work, and finalisation of pension adjustments. No further questions were addressed on the audit in the Q&A. 9fin’s transcript and playback of the conference call is available here

Oriflame has been one of the worst HY bond performers in 2023, with its bonds dropping into the 30s in recent weeks. As we noted in our Cracks in the foundation piece on 23 July the Q2 23 results weren’t pretty reading for the Swedish direct selling beauty group. Declines in sales and membership were troubling and new CEO Anna Malmhake had few options to make-up for rises in inflation. This week the company announced a cost and efficiency programme to save €45m annually, which involved reducing the workforce by 20%, by next month. 

I’ve been spending a lot of time reading about China this week. 

Beijing is bidding to avert a $13tr provincial debt crisis that threatens to spill over into its wider economy, with at least 10 of its regional governments thought to be staring into the financial abyss, says Asia Financial. The publication explains the role of off-balance sheet local government financing vehicles (LGFVs). “The International Monetary Fund estimates 66 trillion yuan ($9.1 trillion) in total debt is held by LGFVs, which cities use to raise money for infrastructure projects critical to the country’s development.”

Intro of the week goes to Robin Wrigglesworth at the FT on the shock victory of Javier Milei in the Argentine primary election and the corresponding market carnage:

“An old macro joke is that there are really only four types of economies: developed, developing, Japan and Argentina….This is an entire country trapped in an unfunny groundhog day. Argentina swings from one political extreme to another, with every fleeting spasm of reform and macroeconomic improvement over the years quickly overpowered by the seemingly irresistible force of simply being Argentina.”

Robin reminds us Milei has promised to burn down the central bank, legalise human organ sales and dollarise the economy (without using any real dollars). Sovereign default number 10cannot be far away. 

Bloomberg law bigs-up the upcoming US Supreme Court decision on whether Purdue Pharma’s $6bn opiod settlement improperly shields the Sackler family from liability. “This is the most important bankruptcy case to go to the Supreme Court in a very long time — the stakes are enormous,” said David Skeel, a law professor at the University of Pennsylvania.

Financial Twitter can sometimes be educational — boo to Elon for getting rid of the free TweetDeck this week — as evidenced by an excellent post from CRE Analyst, who says:

Here’s how the disconnect has halted (CRE) markets.

Values have fallen by 18% in the past 18-months, adding up to $2trn of value loss. The CRE analyst explains how CRE investors typically look for a spread at around 200bps over BBB bonds, and how this effects unlevered IRRs and cap rates. Scarily, this is for core properties, for value-add and opportunistic properties will be much worse. In this WSJ Pro PE article, SLB Capital advisors is even more bearish, saying cap rates rose by 1.5% in Q1, to 6.5%-8.25%. 

Back at the Amex last weekend for the 4-1 home win against Luton, and top of the Premier League for two hours, before Newcastle thumped Aston Villa.

But the big news was the sale of Moises Caicedo to Chelsea for £115m, the third biggest transfer in football history — not bad for a 21-year old who played just 45 premier league games — a 29x return over 2.5-years. Over the past 12-months Chelsea has spent £223m on Brighton players, manager and backroom staff. This is more than the club valuation and the cost of our stadium! 

The Workout is off now for two weeks, with a house move on 22 August (a homeowner again after 20-years) and a compromise agreement on 2 September (also known as a Wedding) — all part of what one of my 9fin colleagues dubbed a full lifestyle amend-and-extend.

Friday Workout — Seeking Permission to Land; Garden Rescue

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