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The One Big Risk for the Markets and the Economy

January 18, 2019

Right now, the biggest risk facing the market is risk. Specifically, the acknowledgment of the possibility that all of the positive underpinnings of the economy and the markets could go away. And that we are doomed to see companies’ profits reverse, credit markets contract, jobs turn to unemployment, consumers’ spending slow and business investment evaporate—all ending in recession.

That is in my view what is behind the selling that we saw in 2018, particularly in December. It is getting difficult to see how pessimism can be completely set aside, even if there is plenty of good news from the economy, like strong consumer and business spending. But let me explain one of the real threats to the market that perhaps you haven’t been following.

Much has been taken from the Federal Reserve and its Open Market Committee (FOMC) this past year over short-term interest rate targets for fed funds and the market’s fears over further money tightening.

But the real challenge isn’t this rate, but what the Fed has been doing with its balance sheet. The Fed stopped buying bonds in the open market after its portfolio had swelled to as high as $4.5 trillion. But last year, the Fed also stopped reinvesting maturities, effectively allowing the portfolio to roll off by some $50 billion per month, to a current portfolio of around $4 billion.

This pull-back has been setting a cloud over the corporate bond market. And joining the Fed, the European Central Bank has also announced that it has stopped buying bonds at year end.

This could spell doom for corporate bonds and other credit markets, but so far those segments are doing fine, fueled by ample demand from institutional investors, including pension funds.

But what is more important than is what is happening in the collateralized loan obligation (CLO) market. This is where companies obtain loans from individual or syndicated groups of banks, which are then either held or pooled and sold into the market, where banks and other financial firms invest in them.

CLOs in their own right are a great means for banks to reduce credit risks in their loan portfolio while also providing investors with higher yields and of course giving companies additional funding opportunities.

But the downside comes when the loans are originated, as they tend to be light in documentation as opposed to traditional origination and sales of corporate bonds. The originators, eager for fee income, can push transactions that might lean on the aggressive side. And buyers of CLOs often don’t or can’t do their homework on what’s really under the hood. Since many of the underlining loans in CLOs are subordinated to corporate bonds (meaning the bonds’ obligations have to be met first), there is additional credit risk if and when something goes wrong.

We saw this in action back in 2007-2008, principally with global banks in Europe—remember that the market often rinses and repeats for good or bad.

The CLO market had been on a tear in the first three quarters of 2018, as companies were eager to raise funds for stock buybacks and other purposes and originators were eager for fees and buyers wanted higher yields.

But that’s now in reverse. From mid-November through year-end, there was a major sell-off in CLOs, beginning a big reversal of the buoyant corporate loan market that has been underway this past year.

Much of this has come with massive pull-outs in funds that own loans, including many ETFs, which have seen billions of dollars’ worth of redemptions. And with this sell-off, the loan market is now not happening for many companies.

This in turn is set to slow stock buybacks. From 2009 through 2017, corporate non-financial debt, including loans, have swelled by $2.7 trillion to a record $6.2 trillion, amounting to 31% of the US GDP. And much of that additional debt has gone to stock buybacks.

In the third quarter alone, S&P 500 buybacks increased 57.7% to a record $203.8 billion, with the 20 largest stocks in the index accounting for 54.3% of all transactions. And 2018 saw the record for most buybacks broken two and a half months before the year was even over.

I see that this drop off in CLOs and loan origination had impacted the demand for stocks through buybacks, which because of the index-driven market is adding to the pessimism selling, creating the bigger drops that we have seen on many of the heavy trading days, particularly in late December.

And adding to this is the dramatic drop in hedge funds, which have seen billions pulled from a $3-trillion-dollar market. And out of the multitude of hedge funds, some 580closed in 2018, as investors are questioning the fees and expenses and lack of superior returns against index funds. So, in turn, hedge funds have needed to liquidate stock holdings, adding to the selling in the S&P 500 and related indexes.

But while the CLO market is indeed a risk, it is worth noting that since the start of the markets this month, the CLO Debt Index has been coming back, rising by 1.95% after dropping 3.73% from the high noted above—compare to the S&P 500, which has rallied so far this month by 4.55%.

The bottom line is that less-than-transparent credit markets remain a threat today, as they were a decade ago. And more awareness makes for a better-prepared dividend investor.