Follow the money…

Given the critical importance of flows and liquidity in ensuring the proper functioning of international economies and markets, the history of financial crises teaches that the old adage “follow the money” does not lose its relevance.

If one looks back over the recent decade, major financial dislocations have largely been the consequence of a rotation of global liquidity and capital (mis-)allocation, leading to mis-pricing of assets and risk: witness what happened in 2007/8 to the “Anglo-Saxons”; to the Euro-area in 2011/12; and now seems to be happening in the so-called Emerging Markets. Couple this with over- and mal-investment in China (and a credit “bubble”), followed by a slowing in demand for inputs and the resulting significant decline in the prices of many commodities, such as copper, coal, iron ore and, most recently, crude oil, and one has the makings of a “perfect storm”, exacerbated by rising economic instability in countries such as Brazil, Russia and South Africa.

It is no wonder that debate rages about the appropriateness of the US Federal Reserve Board raising policy interest rates and the outcomes that could flow from that, particularly given the level of Emerging Markets borrowings in US Dollars by corporates and other entities that do not have a natural hedge of US Dollar revenues. This “original sin” has, time and again, led to significant crises: and would now occur in an environment in which many of the sovereigns who would habitually try to engineer some form of rescue are themselves exposed by higher levels of debt and facing lower levels of expected growth. And bear in mind that these so-called Emerging Markets now account for some 60% of global output.

So, there is a demonstrable risk of a self-reinforcing downward cycle of reduced demand, leading to reduced prices, leading to reduced incomes, leading to weakened capacity to service elevated levels of debt. Such a scenario does not end well.

This environment, by definition, means that careful risk selection and acceptance become even more important than usual, because the probability of defaults increases, while the likely level of recoveries decreases. One can already see this trend in the US O&G space, where the frequency of defaults has increased dramatically during 2015, and is only likely to rise as borrowing bases are cut during the next month or so by banks that are now very nervous about all but their highest quality borrowers. Here too “following the money” is critical: if a company finds its revenues falling; the availability of bank liquidity reduced; and access to capital markets closed, it has to try to cut costs and curtail capex in an attempt to create free cash flow. Many high-yield borrowers have not had to do so for years, because banks and bond investors were willing to fund expansion and negative cashflows resulting from ambitious capex programmes, so it remains to be seen how many of them will survive without a restructuring. US regulators are also now much less forgiving of “extend and pretend”; and publicly disapprove of “leveraged loans” beyond relatively conservative levels, so there will be blood!

At Awbury, we are always focused on ensuring that, when we select, analyze and accept a risk, we can identify and understand the factors that will have an impact on the probability of a loss or claim over the timeframe of our exposure; but that does not mean that we believe that the current environment is simply a threat; because with disruption and fear come opportunities for those with the capacity to discern and price an acceptable risk/reward ratio.

The Awbury Team

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