About 4,000 attendees across finance, government, and other fields earlier this week gathered at this year’s Milken Institute Global Conference at the Beverly Hills Hilton to discuss a wide range of topics, though many centered around disruption, whether in a geopolitical, technological, or regulatory form.
The motto of this year’s conference was “Building Meaningful Lives.”
For all the criticism that gatherings like the Milken Conference and World Economic Forum in Davos receive—sometimes written off as self-serving echo chambers for the “global elite”—panelists this year certainly seemed introspective regarding the new political environment.
“A lot of people are hurting out there,” Canyon Capital’s Mitch Julis said, referring to the millions of Americans who’ve lost industrial jobs over the years.
Then again, the conference offered a starkly different experience for attendees. While there were panels that addressed growing inequality, for those looking to indulge a bit there were plenty of opportunities to do so, whether by sitting in the Bombardier Challenger 350 private jet in the parking lot or attending the various parties in the surrounding mansions, including one this year featuring a live cheetah from the San Diego Zoo.
Credit investors certainly exhibited their animal spirits.
Putting cash to work
Asset prices were generally undisturbed by the myriad geopolitical surprises over the last year, frustrating a litany of investors eager to put capital to work against the low and negative interest rate policy environment prevalent in the developed world. Investors took the conference as an opportunity to better understand some of the secular shifts occurring, whether that means yield-hungry investors seeking non-CUSIP investments or the increasing adversity facing brick-and-mortar retailers.
If attendees came with hopes of more clarity regarding pending policy in the Trump Administration, whether on corporate tax cuts, healthcare reform, or any rollback of Dodd–Frank, they ended up with more questions than answers.
There was also occasional talk about the disintermediation of banks, and the initial discussion of the topic came about in an unusual way.
Perhaps emblematic of the policy uncertainty to come, the conference kicked off Monday with Treasury Secretary Steven Mnuchin laying out a number of upcoming initiatives under the Trump Administration. Mnuchin at one point made the half-serious joke to the audience that “you should all thank me for your bank stocks doing better,” to which most in the audience laughed. But a few hours later that laughter turned to groans as headlines broke that President Trump might be advocating for a 21st century Glass–Steagall Act to break up large banks. Perhaps the crowd in Beverly Hills has become used to these types of headlines, though, as many soon thereafter went about their normal course of business.
Rich valuations, but no immediate signs of a downturn
With the current credit cycle entering its ninth year, market participants, naturally, have been asking how much longer the current cycle can run before the next downturn.
But seasoned credit professionals think such a predefined timeline frames the question in the wrong way, especially given this cycle’s uniquely accommodative monetary policy. A country like Australia, one panelist pointed out, has been in its current cycle for 25 years, though periodically its markets have experienced blips along the way.
Corporate credit fundamentals in the U.S. indicate, for now, that the cycle still has some room to run.
Ares Management co-founder Michael Arougheti said he did not see an earnings recession in either liquid or private credit, although the rate of earnings growth in some instances has slowed. Indeed, EBITDA growth of issuers per the S&P/LSTA Leveraged Loan 100 Index is around 5% quarter-over-quarter, off the highs of 10%-plus growth in mid-2014, though Arougheti noted that credit fundamentals look resilient, compared to how they typically look around this point in past cycles.
Mary DuBose, who co-heads Wells Fargo’s Asset Backed Finance group, concurred, saying that underwriting standards in the middle market space were still prudent, with no decline in EBITDA—with the exception of certain idiosyncratic situations. But the amounts of leverage for borrowers was perhaps “a bit toppy,” DuBose said, in part due to lenders chasing a limited number of M&A transactions.
Given the large amount of money that private equity firms have raised—estimated by Michael Milken at roughly $500 billion in 2015 and 2016—and the benign credit environment, the challenge is finding attractive investment opportunities. “Everything is priced to perfection,” Arougheti said.
So much so, in fact, that investors from Apollo, GoldenTree, CQS, Crescent Capital, and Varde Partners on a later credit outlook panel all expressed that they were “rooting for a correction.”
But for credit investors, often characterized as employing a glass-half-empty approach, many still could not point to any negative catalysts, outside of a geopolitical event.
“We’ve been scratching our heads looking for problems, and that’s perhaps the most worrying part of all,” Crescent Capital’s Mark Attanasio said, adding that he had no interest in buying low-yielding debt, especially those without covenants.
Rise of private lending
Rich valuations in liquid fixed income have consequently driven more investor dollars into the non-CUSIP private lending space, where loans on average have a spread of 150 bps over comparable broadly syndicated credits, with returns ranging widely, from 3–14%.
“We would not be able to grow if we relied on banks to provide CUSIP products for us,” Apollo Management’s Jim Zelter said.
Private loans are more appealing in ways because of documentation that’s more tightly negotiated, compared to those in the broadly syndicated market, which some called “basically covenant free.” The lower leverage and clubbier lending environment also provide an extra layer of safety for assets that are effectively buy-and-hold, Terry Harris of Barings LLC said. Harris reminded attendees, however, that the additional spread pickup comes with additional sweat, as lenders must have personnel on the ground and on-site at the companies they lend to.
Not to mention, like any other origination business, sourcing attractive assets is not necessarily easy. Crescent’s Attanasio illustrated that fact by revealing that, of the 1,300 potential loans that Crescent looked at last year, only 5% were ultimately completed.
Others are finding more innovative ways to lend to a traditionally underserved market. Damien Dwin’s $4 billion Brightwood Capital Advisors, for instance, seeks to lend to businesses that are primarily owned by families and entrepreneurs. Dwin highlighted that a $25 million EBITDA business seeking a $100 million loan currently receives different terms than those backed by a private equity sponsor. Dwin cautioned that the lower part of the middle market still requires an understanding of the nuances that take into consideration more than just cost of capital.
“It’s hard to scale taking single-B risk while charging CCC prices and levering four times,” one lender said.
Any chance of regulatory overhaul?
Panelists across the gamut seemed to express an increasing amount of doubt that any broad changes would be made to the post-crisis regulatory regime. While the Trump Administration has said it would roll back a number of the provisions from Dodd–Frank, those campaign promises are being tested against the sharply partisan climate in Washington. “Dodd–Frank has become a religion,” one panelist said, describing the large divide between the parties.
Proposed legislation, such as the Financial Choice Act from Texas Representative Jeb Hensarling, is viewed as having a very slim chance of passing in the Senate, suggesting that only individual, one-off parts of the bill will be able to pass.
“There seems to be an irrational exuberance on financial regulations coming off,” Mike Sommers of the American Investment Council said.
Political analysts at the conference expect that Hensarling “will not show his cards” on which parts of Dodd–Frank he would try to push forward, but many speculated that the Volcker Rule would be a good candidate.
Critics of the Volcker Rule have complained that the rule is 900 pages long and remains unclear as to what the exemptions are, and what is covered. CLOs under Volcker are considered “covered funds.” In order to be owned by banks, the CLOs are prohibited from owning bonds in their portfolios.
Risk retention was barely mentioned during the discussions except for one caustic comment from a panelist: “It’s ironic that risk retention exempts ‘qualified mortgages’ but applies to assets that didn’t cause the financial crisis.”
The upcoming skirmish to right-size Dodd–Frank, however, will be dwarfed by a far greater battle—corporate tax reform.
Panelists from across the government detailed the steep uphill battle congressional Republicans face to achieve successful tax reform. This includes the daunting task of cutting corporate tax rates from 35% to 15%, pushing through politically unpopular pieces such as the border adjustment tax and/or eliminating the interest deduction, and keeping the plan revenue-neutral.
Ideas were also floated on allowing a special reduced tax rate for corporations repatriating their overseas income and whether to use those proceeds toward infrastructure investments. But even there it seems politicians can’t agree, as arguments have also been made to use taxes from repatriation toward the tax reform plan.
Colony NorthStar CEO Tom Barrack, who was chairman of President Trump’s inauguration committee, seemed to express overall ambivalence about significant changes coming under the Trump administration. “He won’t be as good as we think, but he won’t be as bad as we think,” Barrack explained.
New world disorder
In typical fashion of the Milken conferences, discussions extended outside of corporate credit and regulation, and offered attendees food for thought about broader secular trends and their longer-term implications.
Conference participants generally agreed that technological advances were going to have a widespread impact on the labor force. The question here, however: What is the broader implications of that?
“None of us fully understand the full effect automation has on wage inflation,” PIMCO CEO Emmanuel Roman said.
For all the gains in productivity realized from technological innovations, the consequent job losses have fueled the fire for economically marginalized voters, some of whom have trained their ire, perhaps disproportionately, toward globalization and immigration. A 2016 study from the Peterson Institute of International Economics details that, of the manufacturing job losses between 2000 and 2010, 85% can be attributed to technological advancement while 15% were directly caused by free trade.
Technology already seems to be making its mark in one area, brick-and-mortar retailers, a segment on which a vast majority of the conference seemed pessimistic. TPG’s David Bonderman, for one, did not hide his disdain for the sector. “Sears and J.C. Penney have no future,” he said, adding that he would rather invest in a company like Uber.
Canyon’s Julis also couldn’t see how local retailers could compete with the internet. “People need a Disney-like experience to justify leaving their computers,” he said.
Consequently, the need to effectively retrain displaced workers was emphasized by a number of panelists. But Janus Capital’s Bill Gross had harsh words for America’s university system. “Our education system is broken. People go to college to get a degree, not to get skills for the future,” he lamented.
Perhaps for those unwilling to add onto the near record-high levels of household consumer debt, however, one panelist may have incidentally suggested an idea for those willing to venture east.
China Investment Corporation’s Qi Bin, on a panel discussing whether China would be the architect of a new global order, complained how difficult it was for many affluent parents in China to find an English teacher. He said it wasn’t unusual for English teachers to be able to secure $150-an-hour jobs and get fully booked at that rate for 10 hours a day, seven days a week. The demand is certainly there, as Bin astounded the audience with the fact that there are more people in China looking to learn English than the entire population of the U.S.
White swan, grey swan, or black swan?
A number of credit investors away from the panels reiterated that they couldn’t immediately name catalysts for a sell-off, but some still have been putting on a number of hedges to protect themselves from tail risks.
Leading investors and economists back on panels otherwise did their best to come up with sell-off catalysts. These included more surprise election outcomes in Europe, the breakup of the eurozone, energy prices falling anew, a trade war breaking out, and the Chinese economy crashing.
Janus Capital’s Gross expressed concern that China’s gap between its high-teen year-over-year credit growth and its single-digit GDP growth is diverging, and is unsustainable. Principal Financial Group President Jim McCaughan bluntly described the credit creation system in China as “extend-and-pretend,” but still thought that economy could run in its current form for another five years.
Gross also questioned the future existence of the eurozone, criticizing the “one-size-fits-all approach” of the monetary bloc, saying that the same interest rate for Germany doesn’t work well for France.
Economist Nouriel Roubini, meanwhile, offered a more imaginative black swan for the audience: a successful disruption of the financial system or critical infrastructure by North Korean hackers.
One can only hope such a scenario remains far-fetched. Indeed, not all the disruption scenarios entailed doom and gloom. Rosier views include Former Vice President Joe Biden’s new initiative to find a cure for cancer and Apollo 11 astronaut Buzz Aldrin’s vision to inhabit Mars by 2039.
And then there was Alphabet (Google) Chairman Eric Schmidt. “I want to die on Mars,” he said in one of the opening addresses to the conference, adding at the end, “just not on impact.” — Andrew Park
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