Aurelia Butler

Good morning. Ethan here; Rob’s back on Monday. Another modest stock bounce yesterday. Less modest was Tesla, rocketing up 10 per cent after less-bad-than-feared earnings on Wednesday. The company also sold most of its bitcoin at a fat loss. Somehow Tesla is worse at trading crypto than your nephew.Today, why forward guidance had to go, and a look at leveraged loans. Hope everyone is staying cool out there. Email us: [email protected] and [email protected] ECB scraps forward guidanceAfter the Federal Reserve’s 75 basis point hike in June, we wrote that it’s stupid to do bad policy just because you said you would. The Fed had telegraphed 50bp, but inflation expectations data came in hot, so it had to pivot.The Fed is not the only central bank leaving predictability behind. Last week, the Bank of Canada delivered a 100bp rate increase, to markets’ surprise. And then, yesterday, the European Central Bank raised rates 50bp, tossing its June guidance for 25bp. This was the ECB’s reasoning, from Reuters:We decided to go for a 50 basis point (rate increase) in June and therefore the combined forward guidance that existed for September is no longer applicable. From now on, we will take our monetary policy decisions on a data-dependent basis — we will operate month by month and step by step . . . We debated internally within the Governing Council about the pros and cons of sticking to the signalled 25 basis point (rise) of July which entailed the other forward guidance that we gave in respect of September, and the two of them were clearly a package. And . . . we decided on balance that it was appropriate to take a larger step towards exiting from negative interest rates.The ECB thought about whether its previous 25bp pledge made sense, and decided, no, it didn’t. In so doing, the ECB killed forward guidance, marking “a profound shift in the central bank’s communication strategy”, as one analyst wrote on Thursday.With rates stuck near zero, the idea of forward guidance was to give central banks an additional stimulus tool, jawboning markets into pricing longer-term rates lower. In a calm economy, whether this makes sense is debatable. But it is pointless in one where central banks are raising rates to contain inflation that continues to surprise to the upside. How can they ever know where rates should be, until the moment that they must decide? Ditching forward guidance is less a profound shift in policy than a policy reaction to the profound shifts that have already happened in the economy.Leveraged loan investors are hedging, not panickingA theme we’ve been hitting on in recent days is that everyone is expecting things to get worse soon, but current conditions on the ground are just fine. One more market where that’s happening: leveraged loans.These are bank loans to below-investment grade companies, often used to finance M&A. What makes them interesting is that they are floating rate, a built-in hedge for duration risk. Earlier this year, as interest rate expectations started to rise, this property made leveraged loans some of the best performing assets out there, especially compared to fixed-rate bonds.But duration risk is not the only worry. Credit risk matters too. The sorts of companies that take out leveraged loans tend to have weaker balance sheets, and as such are vulnerable to a Fed-induced recession, or even just a slowdown. A slowing economy plus floating-rate loan payments rising could hurt. Issuers would face rising debt-service costs just as business gets worse.So investors are bracing for recession. Since May, a popular leveraged loan return index has fallen nearly 5 per cent, on par with declines in the high-yield bond market. JPMorgan is offloading leveraged loans at 89 cents on the dollar. Earlier in July, Bloomberg reported that one $500mn deal is being offered at 85 cents, the steepest discount so far in 2022. Issuance is weak and demand is falling. The near-term fear is that a wave of credit downgrades is coming.That’s the expectations bit. Current conditions aren’t nearly so bad. Just look at these default rates (chart from Goldman Sachs):

There are virtually no defaults among leveraged loan issuers, for now.How high will defaults go? Analysts at BNP Paribas calculated in June that market conditions imply a 2 per cent default rate by mid-2023. Many forecasters expect something similar. That is gentle stuff by historical standards; the long-term average default rate is 3 per cent. And as you can see in the chart above, the past three recessions coincided with much higher default rates — north of 8 per cent. Even the Covid-19 recession, with its accompanying flood of government liquidity, saw default rates nearing 5 per cent.Leveraged loans investors, then, are hedging but clearly not panicking. There are two familiar reasons why, Jon Palmer and Nick Kraemer of S&P told Unhedged. One is how resilient the consumption remains, keeping borrowers’ revenues healthy despite increasing margin pressures. Second is the balance sheet buffers accumulated during Covid. Borrowers seized on uber-loose financial conditions to lock in low rates with long maturities. Palmer and Kraemer think it’s probably enough to carry many borrowers through a shallow recession.As leveraged loans sell at discounts, some are spotting opportunities. John Kline, who runs the direct lending and syndicated loans business at New Mountain Capital, pointed out to us that even if defaults spike in leveraged loans (or elsewhere in credit), a discriminating investor can stay exposed without taking on tons of credit risk. This is because defaults are more concentrated in cyclical industries with volatile cash flows, but managers of collateralised loan obligations (who bundle together leveraged loans) often have mandates forcing them to hold a diversified set of businesses, including cyclically sensitive ones. Kline says investing in sectors with more predictable revenue can give you an edge.(This is much easier for a private credit firm than an individual investor. The most accessible vehicles holding leveraged loans are just trying to capture the floating-rate universe, not pick winning industries.)It is always worth reiterating that risks could be building sight unseen. As S&P’s Kraemer wrote in a recent note, the proportion of speculative-grade credit sitting at the tenuous B- rating has bulged, driven by leveraged loan issuance. Under low interest rates, yield-chasing incentivised lower-quality companies to issue leveraged loans, fuelling a boom in CLOs that in turn stimulated more demand for leveraged loans. Kraemer thinks rising rates and recession fears could “test” leveraged loan issuers with the “potential to slow” this feedback loop. Others don’t put it so politely. As Dan Zwirn of Arena Investors told us in March:[CLOs] will keep getting printed, and keep hungering for more debt, and keep creating a perception of ready and able refinancing, until they don’t, at which point it will all spiral backward the other way.Markets, by contrast, are hoping for a soft landing.One good readNeom, the desert megacity planned by Saudi Crown Prince Mohammed bin Salman, is weird: “elevators that somehow fly through the sky, an urban spaceport, and buildings shaped like a double helix, a falcon’s outstretched wings, and a flower in bloom. The chosen site in Saudi Arabia’s far north-west . . . has summer temperatures over 100F and almost no fresh water.” More

MEXICO CITY (Reuters) -The trade union of Telmex, the Mexican telecommunications firm controlled by the family of tycoon Carlos Slim, went on strike on Thursday for the first time in nearly four decades after failing to reach a deal with the company, the union said.Dozens of Telmex’s 60,000 union workers gathered outside the company’s main office in Mexico City after leaving their posts for the strike, the first since 1985. Many chanted, “Carlos Slim, get this, the contract is not for sale,” as passing cars honked in support.Workers said that negotiations broke down over a series of issues they said violated a collective bargaining agreement, including outsourcing work, the exclusion of union members from new Telmex projects, and a lack of investment to cover operational and administrative needs. The union, known as STRM for the Spanish acronym of its name, the Mexican Telephone Workers Union, also said the company has yet to fill nearly 2,000 vacancies that were previously negotiated and wants to change contractual benefits for new hires. Omar Hernandez, 35, a union representative, said the strike is the culmination of years of tension over disagreements in which he said the company disregarded the interests of workers.”The company isn’t changing its attitude,” he said.Telmex, a unit of Slim’s America Movil (NYSE:AMX), said in a statement that the union went on strike after no agreement could be reached that was “financially viable” for the company. Telmex said it would continue negotiating with the union.Union leaders on Thursday afternoon asked workers to vote on a proposal mediated by the Labor Ministry that would create a working group comprised of company and union representatives along with government mediators. The group would aim to find a solution to the dispute within 20 days, according to a document shown on the union’s YouTube channel. The proposal did not define a date for ending the strike. Labor Minister Luisa Alcalde said on Twitter (NYSE:TWTR) that progress was being made towards resolving the conflict, adding she expected an agreement to be reached on Friday.The union said in an earlier statement that Telmex used “coercive measures” while negotiating some aspects of the contract. The union reached a deal last month for some workers to receive 4.5% raises. The union for automaker Volkswagen (ETR:VOWG_p) in Mexico on Wednesday agreed on 9% raises in a one-year contract covering 12,000 workers, after talks in which the union said it stressed rising inflation.Inflation recently accelerated to a level not seen since early 2001, with consumer prices rising 7.99% in the year through June. More

The increase in fees and penalties for purchases of property, farms and businesses in Australia is expected to generate an additional A$455 million ($315 million) in revenue over the next four years, Chalmers said.Chalmers said he continued to back foreign investment in Australia but he had to make the decision due to “the state of the budget we have inherited from our predecessors.””Foreign investment fees will continue to make up only a small proportion of total foreign direct investment,” he said in a statement. The new measures will take effect from July 29.Chalmers earlier this week warned the country’s economic picture would be “confronting” as the government prepares to release updated economic forecasts to parliament on July 28 to account for faster inflation and rising interest rates. The recently elected Labor Government, having promised during the election campaign not to raise taxes, has also warned that spending will have to be trimmed to restrain government debt. ($1 = 1.4451 Australian dollars) More

Activity in the services sector also expanded at a slower rate, suggesting more subdued demand at home as a weakening yen pushed up the cost of imports, raising concerns about the impact that may have on the economy.The au Jibun Bank Flash Japan Manufacturing Purchasing Managers’ Index (PMI) slipped to a seasonally adjusted 52.2 in July from the previous month’s 52.7 final, marking the slowest expansion since last September.The headline figure was pulled down by the first contraction in output in five months and the first decline in overall new orders since last September. New export orders shrank for the fifth straight month.Usamah Bhatti, economist at S&P Global (NYSE:SPGI) Market Intelligence, which compiles the survey, said activity for the private sector overall was marginal.”The expansion in output was the softest recorded since March,” he added. “Companies noted that shortages of raw materials and rising energy and wage costs had increasingly dampened output and new order inflows.””This was notably evident at manufacturers, who recorded a reduction in production levels for the first time in five months,” Bhatti said.The au Jibun Bank Flash Services PMI Index dropped to a seasonally adjusted 51.2 in July from June’s final of 54.0, expanding for the fourth straight month.The au Jibun Bank Flash Japan Composite PMI, which is calculated by using both manufacturing and services, dropped to 50.6 from a final of 53.0 in June.The 50-mark separates contraction from expansion. More

Market research firm GfK said its consumer morale index held at -41 in July, matching June’s 48-year low and below levels that have previously preceded recessions.Economists polled by Reuters had expected the index to edge down to -42.Joe Staton, client strategy director at GfK, said a two-point rise in hopes for personal finances over the next 12 months might reflect optimism after Prime Minister Boris Johnson said he would resign.But the overall index reflected acute concerns about the general economic situation.With inflation heading for double digits from more than 9% in June, the Bank of England is expected to raise interest rates for the sixth time since December next month, despite a slowing economy. It says it is prepared to act “forcefully” if needed. More

BUENOS AIRES (Reuters) – Argentina will allow foreign tourists to exchange dollars at a significantly higher rate than previously available, the Ministry of Economy said on Thursday, as the country reckons with depleted foreign currency reserves. “Argentina needs the dollars brought in by tourists,” Minister of Tourism Matias Lammens told journalists on Wednesday before the measure was announced. “Today, due to the exchange rate gap, many of those dollars do not enter the central bank.”After years of rampant inflation and a spiraling financial crisis, Argentina’s central bank urgently needs to increase its reserves. With tight foreign exchange controls, many Argentines and tourists bypass the formal currency exchange altogether, buying or selling dollars in the black market. Currently, dollars are worth more than twice their value in Argentine pesos in the black market than at the official rate. The measure to be adopted by the country’s central bank will allow foreign tourists to sell dollars at the financial markets rate, known as MEP, that is much closer to the black market rate.”We are working so that tourists effectively liquidate those dollars (…) to the formal exchange market,” Lammens said. Foreign tourists will be allowed to sell up to $5,000 in authorized entities by presenting the identification document used to enter the country, the economy ministry said. The exchange operators should require a sworn statement from the client stating that the person is a tourist and that, in the last 30 days and in the group of entities, has not carried out operations that exceed the equivalent of $5,000 dollars, the central bank said. More