Bilal’s Macroscope: 3 Corners of the Financial System to Worry About

Note: You may not see much written output from me next week as I am heading out to Dubai to see clients, but feel free to message me if you have any questions.

We already know US regionals and European banks with AT1 exposure are at risk. Additionally, I have written a lot on private equity. Here are three other areas I am worried about:

• Leveraged loan market. This is related to private equity as they are big users of leveraged loans to finance buyouts. Essentially, leveraged loans are loans given to companies with low credit quality. In 2013, US issuance crossed $1 trillion for the first time. Between 2016 and 2022, it averaged $1.2 trillion per year (Chart 1). Issuance has collapsed this year.
  
  How many of these previously issued loans will default? Certainly, the rise in yields and, hence, leverage loan rates will make it harder for them to be refinanced (Chart 2). Moreover, banks may be scaling back their willingness to issue new loans. And if we get a recession, then defaults will likely surge.
  
  How would this transmit through the system? Bank of America, JP Morgan and Wells Faro would likely have some exposure, given they are the biggest bookrunners in this market. But typically, the bulk of leveraged loans get packaged up into collateralised loan obligations (CLOs). These are then bought by asset managers and asset holders, such as pension funds and insurance companies. They would suffer losses and may end up selling their holdings.

• Commercial real estate (CRE). Anytime yields are low, real estate does well. The monetary and fiscal stimulus after COVID saw commercial real estate prices surge. Between March 2021 and March 2022, US industrial unit prices jumped 25%, apartment block prices jumped 23%, retail units jumped 20% and even office blocks rose 13% (Chart 3). The trouble is that price gains are moderating and, in some cases, turning into annual declines (apartment blocks and offices). This could prove problematic for banks with exposure to these sectors.
  
  Screening US banks, we find smaller banks have a larger share of their loan book exposed to CRE. Notable banks to look out for would be New York Community Bancorp (they also just bought some assets of failed Signature bank), and valley National (Table 1). Both have loan books of around $40bn with more than half in CRE. Meanwhile, the larger banks like JP Morgan, Citi and Bank of America have exposures less than 15% of their books to CRE. Europe has similar issues, notably the Nordic markets.

• ESG funds. This may seem odd, but aside from performance issues, there are regulatory and legal risks around greenwashing. Many funds may have classified themselves as ESG but may not meet independent verification. Already, news sources suggest MSCI is in the process of reclassifying companies.
  
  The trouble is that there has been a surge of inflows into ESG funds. Focusing on ETF markets, we find that since the starting of COVID, almost $500bn of flows have gone into ESG ETFs (Chart 4). Were these flows to reverse, asset managers could suffer losses, which in turn could induce other outflows. Moreover, if ESG ratings were to be found to be ‘manipulated’ this could become the next big financial scandal.

Our Current Discretionary Trades

While the Macro Hive Model Portfolio survived the SVB crisis, it has a harder time over the past week. We have made three changes, taking profit on long UK 2Y and adding two EM FX trades. here are the details:

1. Long 5Y TIPS vs US 2Y (target: 90bp) – read here.
   • Trading the Fed need not be directional. Mustafa sees value in buying TIPS and hedging it with the nominal US 2Y to trade both the ‘end of the Fed cycle trade’ or the ‘hard landing’ scenario.
2. Short BTP vs Bund 10-year (target: 220bp) – read here.
   • Henry sees the BTP vs Bund 10Y spread trade reaching 220bp.
3. China re-opening – read here.
   • Long SHCOMP (target: 3,600)
   • Short USD/CNH (target: 6.65)
   • Short USD/COP (target: 4,100)
4. Receive 2Y INR OIS (target: 6.0%) – read here.
5. EM free to rally with Fed ending – read here.
   • Short USD/IDR 3M NDF (target: 14,000)
   • Short EUR/CZK (target: 23.25)

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)