Lack of punctuality is a problem for those with a bearish outlook. I’m maintaining mine, as inverted US Treasury yield curves were an unerringly accurate leading indicator for past recessions. But they have managed little consistency in predicting when recessions will show up.

Halfway through 2023, and a year into this Treasury inversion, surface numbers are robust if not strong for financial assets and it’s still far from certain which of the identified cracks will turn into fissures. The picture of gushing equities and soggy sovereign bonds is also the exact opposite from what most analysts and investors predicted going into January.

More than enough warning is coming, however, from the rumbles coursing through the global economy. And Greeks that have borne gifts — by which I mean mainly beta credit strategies — could instead bring shocks.

Socrates learned the hard way. Having failed to pay attention to his wife Xanthippe’s remonstrations, he ended up with a chamber pot tipped over his head — occasioning the line I quoted above.

In the structured finance landscape, not all deals are equal — as my colleagues’ deep dive on whole business securitisations attests (see links in opening paragraph).

Today there are asset classes like CMBS and RMBS that give me existential angst, while others like CLOs inspire stoicism in the face of the worlds troubles. Partly it’s their track record through numerous past tests, but also their performance this year feels less in thrall to technical distortions or bubble dynamics than some other assets. CLOs dealt exceptionally well with whatever 1H23 threw at them — including the bank stresses of March and April. 

They have remained an attractive proposition for investors, resilient at the top end of their capital structures, and now there’s as much talk of issuance normalising as there is of macroeconomic concerns. Indeed the CLO issuance taps in the US went back on last week, with a good flow of deals including Bain and Aegon.

One argument for increased CLO opportunity, particularly in the secondary market, is that 40% of deals should hit the end of their reinvestment period by year-end. This is not without challenges, but means investors can position tactically on CLO bonds they expect will deleverage quickly.

We’ve spoken in recent weeks about the need to watch out for downgrades and defaults, which would increase volatility in CLOs’ lower rated tranches. More triple Cs would mean a reappraisal of weighted average rating factor (WARF). But today’s high coupons are great compensation and there’s rewarding convexity in amortising deals, with plentiful carry and the prospect of getting called.

Hedging will help, which should be a practice CLO investors are well versed in by now. Since writing my appraisal of the Global ABS conference in Barcelona last month, I’ve had a few pointers on the best way to place and time these. 

David Nochimowski, head of global CLO and ABS strategy at BNP Paribas, points out that equity put options, such as on the SPX (S&P 500) index, might be a better recourse for US CLO junior mezz hedging than CDS indices and tranches. Merits include their broader underlying universe, responsiveness and ease of placement.

“They tend to be quite reactive to market moves,” says Nochimowski. “The cost of the option is the downside, which is therefore limited. Short-term technical factors in credit can be used as a hedging signal.”

Chaos theory

June encapsulated the dizzying array of contradictory outlooks and numbers that investors will have to grapple with in the second half. 

Market expectations have shifted back to a ‘soft landing’ base case on the hope that disinflation velocity will appease central banks, yet they have largely maintained hawkish outlooks and in some cases — notably the BoE, Bank of Canada and Norges — shocked with tighter policy moves. 

US jobless claims falling back to 239,000, versus an expected 265,000, will do little to gratify the US Federal Reserve on its decision to pause hikes, particularly as this was the biggest weekly decline since October 2021.

Mid-month the World Bank increased its 2023 global growth projection from 1.7% to 2.1%, while the OECD gave a more optimistic reading of 2.7%, picking-up to 2.9% next year. 

Source: World Bank

But plenty of strategists still see recession as the most likely outcome. Deutsche Bank, for one, said on Friday it thinks the US recession starts “in Q4 with risks that it gets delayed to Q1 rather than doesn’t happen”.

“There’s a long long way before you can be sure you’re out of the gravitational pull of the lag of aggressively tighter monetary policy over the last year or so,” they wrote. “Remember that this time last year the ECB was only about to end QE on 1 July and hike rates at the end of that month.”

Yet DB itself admits that it’s been “in general a good half year for risk” with yield-curves steepening and sideways movement in long-term bond yields “unless of course you’re in the UK”.

By their reading the S&P 500 is +14.5%, the Nasdaq +29.9%, FANG+ +70.9%, Stoxx Europe 600 +7.5%, two- and 10-year USTs +43.4bps and -3.7bps, two- and 10-year Gilts +170bps and +71bps, iTraxx Crossover -68.7bps, CDX HY +1.4bps and with crude oil -13.47%.

Source: Trading Economics

Here I circle back to what I said earlier about technical distortion and bubble dynamics. DB cautions this has mostly been a rebound from stressed levels in 2022, with AI gains the added kicker. And since the central bank rate hiking era began 18 months ago the only winners really have been commodities, gold and Italian equities — with commodities a slight outperformer if adjusting for 8% US inflation since then.

“Gilts are down a stunning c.-33% in US dollar terms and over -40% in real terms — a wipe out that could take a decade to make back in nominal terms and much longer in real terms.”

How to navigate this labyrinth? Another philosophical breakthrough points the way. In Darren Aronofsky’s 1998 debut feature film “Pi”, genius Max Cohen is driving himself to destruction trying to apply mathematics as “the language of nature” to find an underlying order in the seemingly random walk of the stock market. Under extreme tension he visits his old mentor, who reappraises Archimedes’ eureka moment following weeks of sleepless frustration.

Sol: Now, what is the moral of the story?

Max: That a breakthrough will come.

Sol: Wrong! The point of the story is the wife. Listen to your wife, she'll give you perspective. Meaning, you need a break. You have to take a bath or you'll get nowhere. There would be no order only chaos. Go home, Max, and you take a bath.

At the halfway point of 2023, it makes sense to step back for some perspective. Many investors will focus on how to protect those gains, yet the promise and risk are high for those looking to capitalise on further uncertainty. Volatility is close to all-time lows so it’s easy to predict things will become less settled. But in the run-up to the most anticipated downturn ever, the biggest cyphers may lie with who is taking a bath.

Author’s photo, from a wall in Athens

Grey water

The UK stands out for receiving an absolute deluge.

Thames Water’s £14bn debt problem — and its oversized dividend payments since 2000 under both Labour and Tory governments — have opened a huge debate about whether public utilities are suitable for privatisation. Ironically, the Tories’ ability to deal with the situation is compromised by clauses in nearly £600m of the company’s debt that investors inserted as protection against Labour re-nationalisation proposals ahead of the 2019 general election.

The UK is one of the rare examples around the world where water has been fully privatised, and arguably its early years during the 1980s did improve security of supply. But Greece, which has as long a history in water management as just about anyone and whose sovereign bonds have actually done well this year — would do well to heed the recent history as it considers the prospect of privatising its own natural resource.

“Thames Water's financing situation exacerbates the challenges facing the water sector,” wrote Jefferies equity analysts in a note today (Monday). “The sector faces an increasingly difficult challenge of balancing the growing need for environmental capex with customer affordability, whilst also enhancing its financial resiliency. This suggests rising regulatory risks for UK water which supports our view that listed companies should trade close-to-nil premium to regulatory capital values.”

But it’s hard not to see this long-channelled crisis as symptomatic of the country’s broader malaise. Amid the watery whirlpools and BoE dousing the country’s growth prospects with rate hikes, less headlines have been given to a charter agreed by the government and lenders to protect 85% of the mortgage market. 

This suspends repossessions for 12 months from the first missed payment, while borrowers up to date on payments will be able to switch to interest-only payments for six months or extend their mortgage term. Affordability checks will be waived on re-mortgaging and borrowers can lock in a deal up to six months before they exit the reset period (affecting up to 800,000 mortgages in 2H23).

Arguably this brings relief to a lot of people who would otherwise be in difficulty. But the fact it was deemed necessary shows the headache for countries trying to rebalance rates versus inflation when debt loads are so high.

UK mortgage rates

And the charter doesn’t cover buy-to-let mortgages — the assets that happen to make up a large part of the underlying collateral in UK RMBS deals. These look like they will become increasingly pressured as debt costs rise, raising the prospect that more inventory could hit the market if owners cave. 

Problems are also mounting for AirBnB and other short-stay property owners as bookings dwindle. As of 14 March 2023 there were 75,241 listings in London alone, according to Inside Airbnb’s data, of which 45,714 (61%) were for entire homes rather than rooms within a home. This partly explains why London rental prices have been kept high, given the impact short term lettings have on the availability of long-term let accommodation. But a reversal in this trend would in turn have a negative impact on the prices buy-to-let owners could charge to renters.

Such were my thoughts as I sneakily wrapped up this column while strolling round the Lyceum of Aristotle, a kilometre or so east of the Acropolis and Prison of Socrates. Aristotle is associated with the idea of the golden mean, and I can’t help but feel he’d intuit why mean reversal is going to be painful in H2 for overbought assets.

As for me, I managed to juggle the competing calls of history, culture, Thames Water and relationship harmony.

What a relief!

source: me, at the Museum of Archaeology in Athens