Distressed debt markets have four themes emerging, according to a new paper issued by the Wells Fargo Investment Institute They are: the consequences of central bank tightenings around the globe; the elevation of debt levels, also something happening globally; the regulatory pressure over non-conforming loans (especially in Europe); and the rise in geopolitical tensions.
Together, these themes add up to an opportunity for investors to pick up on the distressed debt that is being and will be created. These opportunities exist both for liquid hedge funds and for illiquid private debt funds.
“Trees don’t grow to the sky,” as the late Louis Rukeyser used to say, and an upward movement that is now close to 10 years old surely won’t go on forever. When this one turns because of the particular combination of those four themes, there will be “meaningful price dislocations,” which will be ripe for exploitation by those with extensive experience underwriting and the necessary scale to successfully capitalize.
The Institute comments on these four trends in the above order. As to the central banks, it observes that though the two big ones, the Federal Reserve and the European Central Bank, get—and warrant—a lot of attention—the central banks of three important emerging economies have recently tightened policy to defend their currencies. In each case (India, Indonesia, and Turkey) the currency had fallen to historic lows, so it is understandable that the central banks have acted as they have, but in so doing they “may have put the brakes on near-term economic growth prospects.”
Debt: GDPs and NPLs
As to elevated debt: Wells Fargo tells us that there has not been much by way of “fiscal restraint” since the global financial crisis. In its absence, debt levels have gotten to or at record highs in many economies.
In the United States, atypically, total debt as a percentage of GDP has been flat lately. Stated as a percentage of GDP it was below 300% at the start of this millennium. It got up to roughly 370% in the build-up to the GFC and then fell back to 350% by 2011. Since then it has been quite flat with a slight downward slope and is now at 344%.
In Canada, which is more typical of world patterns, debt was flat in the years before the GFC. The debt-GDP ratio was in the neighborhood of 200% in the opening years of the millennium. It started rising as a consequence of the crisis and has kept on increasing. It is now at 249%.
The European Union likewise has a total debt-to-GDP ratio of greater than 200%. Several important economies are above the continental average, including Ireland, the UK, France, Spain, and Italy. This has left many households and corporations in those countries “vulnerable to economic slowdown and potential future higher interest rates.”
This brings us to non-performing loans (NPLs). Wells Fargo reports that they remain elevated, especially in European economies. This fact weighs on the profitability of the banking sector especially in Ireland, Portugal, Spain, Italy, Greece, and Poland.
Finally: geopolitics. The paper observes that the US is now engaged in simultaneous trade wars with several of its key trading partners, including Canada, the EU, and the PRC. Also, the rolling Ukraine crisis that has been underway since 2014 and that may be intensifying now has set the EU at odds with Russia. Sanctions on Russia have hampered trade.
Brexit: Deal or No Deal
There is also, of course, and under this broad “geopolitical” heading, some discussion of the impending exit of the UK from the EU to consider. As of October 2018, when the report was written, there was (and in early December there still is not) “clarity on the means by which the United Kingdom will leave the EU on March 29, 2019.” The possibility that there won’t be a deal itself increases volatility.
The odds of a no-deal Brexit, by the way, might have decreased at least slightly since this report was issued. Prime Minister May and her cross-Channel negotiating counter-parties have presented a deal. But May’s government needs 320 votes in Commons to allow this to be ratified before the deadline. Thus far, newspapers tell us, she has only a reliable 240 in her pocket. That is, says the Express, still “a way off.”
Much of this is of course bad news for a lot of operational businesses, but good news for those who are, or may soon be in a position to trade on debt that does or may soon trade at a large discount to its face value.