Friday June 9

Stock indices were mixed today to finish off the week. The S&P 500 fell less than 0.1% to 2,431 while the Dow Jones rose 0.4% to 21,271. Over the course of the week those indices were 0.3% lower and 0.3% higher respectively. Today the KBW Bank index rose 2.3% while utilities were unchanged. Banks may be benefiting from the slight increase in yields throughout the week. The broader market reactions of the UK election outcome seem to be fairly muted. UK stocks and the British pound have repriced 1% higher and 1.8% lower respectively however on a more macro level there doesn’t appear to be a reaction. A big risk now in the UK is that Theresa May resigns given the election result which would usher in a period of serious uncertainty heading into Brexit negotiations. The silver lining may be that it could result in a softer Brexit. Now that the eventful week has passed without too much turbulence in financial markets it is widely expected that the Fed will raise interest rates when it meets next week. Economic data today was light, however it did show that inventories fell 0.5% last month which lower than expected. The 2 year Treasury yield rose 3bp to 1.35% to reflect higher rates from the Fed. The 10 year Treasury rose 3bp to 2.21%. Accordingly 2yr vs 10yr finished at 0.86%. The dollar was mixed against peers however little changed on the aggregate. USD fell less than 0.1% against EUR to $1.1198. USD rose less than 0.1% against JPY and GBP to Y110.29 and $1.2740 respectively. Oil prices finished slightly higher after a tough week. WTI rose 0.4% to $45.82. Brent rose 0.6% to $48.15.

The outcome of the UK election complicates the negotiations for Brexit. Theresa May’s Conservative party finished with just 318 parliamentary seats when it needed 325 to secure a majority. Additionally many members of the Conservative party may go rogue and sabotage May’s Brexit talks since they want a very hard Brexit. Already she has talked about forming a coalition government with Ireland’s Democratic Unionist Party, however that party still supports free movement of people and goods, as well as some other perks of EU membership that already exist now. Since the DUP is so small it would only give May the slimmest of majorities, and may not be enough to compensate for her members of her own party going against her. If May shifts more in line with that line of thinking to secure a majority then it would result in a softer Brexit. The leader of the opposition party Jeremy Corbyn does not have support of his own MP’s so it is unlikely that the party would be able to unite and work together either. Ultimately the election gives UK politicians with no mandate from its people in how to approach Brexit negotiations, and it leaves no political party with the votes or authority needed to make tough and strong decisions. The big risk here is that the negotiation period ends with no deal in place. That would have the biggest downward effect on the pound. On the other hand if parties are able to work together, the resultant deal would likely be more of a softer Brexit which could be beneficial over the longer term. However for now the pound continues to fall given the uncertainty. Gilt yields have fallen as the government bonds are serving as a haven asset at the moment. However if over time political uncertainty starts to scare away international investors, who own 25% of the country’s debt, then yields could drift higher. Yields could also be driven higher by a less effective government being unable to pass reforms to reign in fiscal spending, which could force the BoE to cut rates.

US auto parts manufacturer Superior Industries unsuccessfully tried to include a controversial provision in a high yield bond it was issuing in Europe, however investors successfully pushed back on its inclusion in final terms. The clause in the bond deal’s terms would have allowed the company’s “restricted subsidiaries” to make investments in “unrestricted subsidiaries.” Investors in risky debt didn’t like that because they felt that it would allow the company to transfer value to subsidiaries that bondholders don’t have control over. After pushback from investors issuers got rid of the clause from the EUR 250mm eight year bond offering. J. Crew, which is owned by private equity firm TPG, used a similar clause in a bond offering that allowed the company to carve out intellectual property to a new shell company, and it is not trying to issue debt against that company as collateral. However original investors are in legal dispute with the company over that since they feel they had original claim on the IP. Investors were concerned because TPG also has a preferred equity stake in Superior Industries. Provisions in high yield debt are oftentimes an important indicator of demand for credit. As demand for credit increases and the market becomes more hospitable for issuers, covenants generally get more relaxed as they have been in recent years. However this is an example of investors pushing back on relaxed terms.

Author, former banker and former banking lawyer Martin Lowy wrote in a guest post on FT about some characteristics of the next financial and economic crisis. He starts out by addressing the well publicized increase in debt outstanding. This includes the observation that private and public debt outstanding relative to GDP or corporate earnings has increased dramatically, as has the amount of dollar bonds issued by international issuers. Many analysts have commented that given the high amount of debt issued that could lead to the next financial crisis. Rather than looking at the issuers of the debt Lowy finds it more useful to look at the investors of the debt. In 2008 he argues that it wasn’t the debt itself that caused the financial crisis, but the reactions and forced selling of the institutions who held the debt. Lowy breaks down investors into four categories. Individuals, unlevered investment firms, levered but well capitalized firms, and levered and undercapitalized firms. Lowy asserts that the cause of financial crises is levered and undercapitalized firms who fund their purchases of risky debt with short term borrowings. When liquidity dries up they are forced to sell into a distressed market which exacerbates the problem. Many of these types of firms and investment companies are gone following 2008, and regulations such as Dodd-Frank and Basel III force banks to be better capitalized. Since individual investors, unlevered investment firms, and better capitalized banks hold more debt now and will not necessarily be forced into panic sales, Lowy believes the next wave of defaults in a credit crisis will be followed by an economic crisis as opposed to a financial crisis. This will be characterized by individuals having to cut back on their personal spending since they will take large losses in savings and investment accounts. That could result in a crisis that is longer and deeper that could have bigger impacts on standards of living.

Friday June 9

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