What is Bank Liquidity and Why is it Important?

The global financial crisis of 2007 – 2009 is a classic example of what happens when banks do not have enough cash to pay their debts, e.g., all those items on the liability side of their balance sheets. The reasons for the named financial crisis have been written about and discussed and dissected many times, which is why banks and other financial institutions have to adhere to very strict rules implement by their own authorities, on the back of the Basel iii Agreement*.

*The Basel iii Agreement was implemented in 2009 after the global financial meltdown, this agreement was produced by the Bank for International Settlements in conjunction with 28 central banks from across the globe. This agreement was designed to promote stability in the international banking sector and is a set of reforms to mitigate risk that require banks to keep certain levels of liquidity and maintain certain leverage ratios.

Simply put, banks are now required to maintain adequate cash or assets that can be easily turned into cash to meet the demands of depositors and financial market counterparty transactions in the event of an economic shock as seen in the global financial crisis and in events in March 2023. If liquidity rules are revoked in any way the results can be catastrophic as in the failures of Silicon Valley Bank and Signature Bank in March 2023, which also resulted in a run on other banks.

These failures were put down to President Donald Trump signing into law a bill that reduced scrutiny on banks with assets under USD250 Billion. This was down to the naive thought that with the extra liquidity now available to certain banks, they would be able to invest the funds profitably. What became clear, however, is that these financial rules make a huge difference, and are truly there to stop banks failing. 

Sadly, it appears that despite financial disasters, lessons are never learned and the next financial crisis could be just around the corner. If this is the case, it is hoped that throughout the major financial centres in the world, the banks have got their houses in order. Indeed, last year the vice president of the European Central Bank announced that banks in Europe had robust liquidity and high capital ratios and depositors would be safe in times of economic stress. Furthermore, recent announcements from the Federal Reserve in the United States advise they will stress test thirty two large lenders in scenarios under severe economic shock.

Today it appears that financial authorities and regulators have put in place (or are putting in place) sufficient regulations and stress tests that will satisfy the Basel iii agreement. However, extreme vigilance must be constant by authorities and political masters should be advised to keep well away from the rules and regulations of banking systems. Financial shocks always come as a surprise, so it is always important to make sure that the regulations implemented to protect society are followed to a letter, and not just undone the moment someone forgets about the last crisis.

What is Basis Trading and How Does it Affect the Treasury Bond Market?

Basis trading is a financial trading strategy regarding the purchase of a particular financial instrument or security (in this case Treasury Bonds) or commodity, and the sale of its related derivative. In this example, it is the purchase of a Treasury Bond and the sale of its related futures contract. In the treasury market, the trade is centred on the price differential between treasury bonds and their associated futures contracts.

From time to time, due to heavy purchasing of Treasury bond futures by insurance companies, institutional investors and pension funds*, the bond futures price rises above the price of the underlying bond. Once this price differential is in place hedge funds take advantage of this price differential and will buy Treasury bonds and at the same time sell corresponding Treasury futures. The upshot of this trade is that by selling the higher priced bonds in one market and buying the cheaper priced bonds in another market, the hedge funds can profit from the price differential. 

*Purchasing Treasury Bond Futures – Asset managers instead of buying actual Treasury bonds quite often prefer to buy futures because there is less upfront cash to pay. 

However, the profits from these trades are very small, and therefore heavy borrowing is required in order to make them more lucrative. Sometimes when there are unexpected episodes or events, this can quite often lead to market volatility leading to potential tragic consequences for the trade leaving the trader no option but to straight away unload all their holdings. This form of arbitrage*, as mentioned previously, requires heavy borrowing, and hedge funds usually borrow from the Repo Market**. It is normal for hedge funds to offer their Treasury bonds as collateral, as the normal practice is to roll-over these loans on a daily basis. Experts advise that these trades can be quite risky due to the amount of leverage involved (on average USD50 for every USD1 invested so 50 times leverage), plus a big reliance on short-term borrowings. 

*Arbitrage – the simultaneous buying and selling of currencies, commodities or securities in different markets or in derivative forms in order to take advantage of the differing prices of the same asset.

**Repo (Repurchase Agreement) Market – In this market money market funds, banks and others lend short-term capital against government securities, in this case US Treasury Bonds. Basically, in this transaction a borrower temporarily lends a security to a lender for cash with an agreement to buy it back in the future at a predetermined price. Ownership of the security does not change hands in a repo transaction.

When the Treasuries market experiences volatility, it can increase the cost of the trade thereby negating profitability, so hedge funds must very quickly unwind their trades in order to repay their loans thereby increasing volatility in an already volatile market.  Such fluctuations can see liquidity drying up and a decrease in the availability of buyers. In such instances* the Treasuries market can literally seize up, and with Treasury bonds being so fundamental to the credit market (and they are risk-free), the US Federal Reserve has had to intervene when the normal functioning of the market has become impaired. 

*Onset of the CoronaVirus – Back in 2020 when the Covid-19 appeared the huge volatility in the markets prompted margin calls in Treasury bond futures, amplifying funding problems in the repo market. Simultaneously, Treasury bond holdings were being dumped by foreign central banks in order to prop their own currencies with US Dollars. This prompted cash bonds to underperform their futures counterparts which is the opposite of the conditions needed for the basis trade to make a profit. It was never fully understood how much basis trading contributed to the turmoil in the market, but the rapid unwinding of positions by hedge funds certainly increased volatility. The upshot was the Federal Reserve promised to buy trillions of dollars of Treasury Bonds to keep markets running smoothly whilst providing the repo market with emergency funding. 

Basis trading subsided after the 2020 debacle but returned in early 2023 due the Federal Reserve monetary tightening policies by raising interest rates a record eleven times in eighteen months, which pushed up yields on 10 year Treasury bonds to circa 5%. On the demand side, this yield (highest since 2007) once again attracted large institutional buyers to buy futures, and on the supply side the Federal Reserve has increased sales of bonds to fund the US Government deficits, which has put downward price pressure on cash bonds. Therefore there is now a sufficient gap between the price of cash bonds and futures to have basis traders up and running again.

Financial watchdogs and authorities are unhappy over these trades, specifically because they are highly leveraged, and the fact that they are direct from one party to another. This means regulation is difficult, plus hedge funds themselves have much less regulation than banks. To this end, the Bank for International Settlements (BIS), the Bank of England and the Federal Reserve have called for closer monitoring of basis trades. Indeed the US Securities and Exchange Commission (SEC) finalised a rule in May of this year (starting June 2024)requiring all private funds to report sudden large losses, margin increases and any other significant changes.

Due to Government Crackdown, Chinese Quant Funds Suffer

 For many international investors who are eyeing the Chinese equity markets with suspicion, the recent and sudden trading restrictions is yet another reason to avoid the markets. Indeed, until February 2024, China has endured a record outflow from the equity market, and due to never before seen crackdowns on the property and tech sectors, foreign direct investment is at a thirty year low. Furthermore, as a result of the Chinese government’s efforts to halt a USD$ Trillion sell-off in stocks the Quant industry*, (once a booming and integral part of the equity market) it has suffered losses and is yet another casualty of government policy.

*Quant (Quantitative) Fund – This is a fund that identifies with automated algorithms and advanced quantitative models together with statistical and mathematical techniques to make investment decisions and execute trades. Unlike other funds (e.g., hedge funds) a Quant fund has no human judgement or intellect in investment decisions, and experts argue that the computer based models mitigate losses and risks related to human fund management. 

Market analysts advise that the new restrictions will require Quant funds to be scrutinised and regulators will demand that any new entrants will have to report trading strategies before actually trading. Apart from sweeping regulations that are harming Quant funds, they have been caught off-guard by government intervention. Due to the five year low on the *CSI 300 index, they took very hard and forceful measures to stabilise the markets, with Quant funds firmly in their sights.

*The Shanghai Shenzhen CSI 300 Index is designed to replicate the performance of the top 300 stocks traded in the Shanghai and Shenzhen stock exchanges and is weighted for market capitalization. As such, it is seen as a blue-chip index for mainland Chinese stocks.

First of all, in early February 2024, the head securities regulator was dismissed and replaced by a veteran known as the “Butcher Broker” due to his previous record of hard crackdowns Experts suggest that Quants were targeted as the authorities were concerned that declines in equities were compounded by Quant funds making short bets and unloading large blocks of shares. Therefore some Quant funds were limited in their ability to undertake short trades, which, combined with shifts in the market, inhibited and stifled Quant funds. 

Analysts advise that a favourite trade for Quant funds is purchasing small cap stocks as they are susceptible to mispricing and the quants computer programmes exploits this opportunity to gain profitability, whilst hedging market exposure by shorting index futures. However, declines in small cap stocks made sure that quant funds reduce holdings and the huge selling triggered losses in the derivatives market known as snowballs*. This caused further panic in the market (known as a quant quake) and index futures were dumped by brokerages as well. 

*Snowballs – A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Finally the volatility that was in the equity markets impacted those funds (e.g. hedge funds) who had invested in what is known as market-neutral products* and in many cases had leveraged themselves up to 300%, thus forcing them to unwind their positions creating even more havoc in the market which was already going south. This prompted the authorities to prop up exchange traded funds via government-led funds known as the national team, which resulted in a boost for large caps stocks but ignoring the small caps. Data released showed some of the top Quant funds lagging behind the CSI 500 Index (a well-known indicator of the performance of Chinese mid and small cap companies), by circa 12 points for 2 week’s ending 8th February 2024.

*Market Neutral Products – These funds/investments are designed to target returns that are independent of market directions. This is achieved with equal long and short positions in any industry and by investing in equities where the long positions are expected to outperform their peers and the short equities are expected to underperform. Any losses in the short position are offset by profits in the long position.

Following the crackdown on quants the main equity index has risen in nine straight sessions including every day from 19th -23rd February 2024, the longest run of uninterrupted gains in six years. So for now, the strong arm tactics of the authorities are working to stop the downward spiral of equities, however experts wonder if Quant funds will continue operating where there are such arbitrary market interventions. The question is this: will investors be convinced this a one off intervention? Or will the image the authorities have tried to create over the last thirty years that China is committed to a professional and open market be soured?

 The Continuing March Upwards of Private Credit

Private credit can trace its roots back to the 1980’s where companies with strong credit/borrowing records were being loaned funds directly from insurance companies. However, post the 2007 – 2009 Global Financial Crisis, private credit really came into its own as an alternative to bank lending, especially as financial regulators were cracking down on those deposit taking institutions who were involved in risky lending. In today’s market, private credit has become a major contender in the loans market, and a serious rival to banks and similar lending institutions.

As of June 2023, data released shows that global closed-end private debt funds* have assets under management of circa USD1.7 Trillion, whereas as of close of business December 2015 global assets under management were circa USD500 Billion. Indeed, expert money managers suggest that by 2028, due to possible massive shifts in the financial markets, borrowers would flock to the front door of private credit funds, boosting the value of the global private debt market to USD3.5 Trillion. 

Closed-End Fund – This fund is a type of mutual fund, and in order to raise capital or investment, the fund issues a fixed number of shares through a one-time initial public offering (IPO). The shares can be bought and sold on a stock exchange if the fund is quoted, but no new money can be received into the fund once the IPO closes. Access to closed-end funds is only available during a New Fund Offer (NFO).

Open-End Fund – As opposed to a closed-end fund, the open-end fund such as mutual funds and exchange-traded funds (ETF’s) accept new capital on a constant basis and also issue new shares. 

Mutual Fund – This is an investment opportunity where monies/investments are received from a wide range of individuals and pooled together in order to purchase a wide range of stocks, bonds and other securities. Funds are managed by professional money managers and are structured to match the prospectus where the investment objectives are stated.

Private credit is responsible for providing a vast amount of financial resources into a number of differing investment strategies, some of which are outlined below.

1.     Mezzanine Finance – Mezzanine loans or capital can be structured either as subordinated debt or as equity which is usually in the form of preferred stock. Mezzanine financing is recognised as a capital resource which can often be seen as subordinated debt and sits between higher risk equity and less risky senior debt. To facilitate the explanation of mezzanine debt, below are the definitions of senior debt and subordinated debt.

·      Senior Debt – often issued in the form of senior notes and also known as a senior loan, is a debt that will be paid first by the borrowing company. In other words, it takes priority over other unsecured debt and in the event the borrowing company goes into liquidation, owners of senior debt will be the first to be repaid.

·      Subordinated Debt – or as the name implies junior debt, is usually the last type of debt to be repaid. It has a lower status to senior debt and hence the name subordinated debt. Typically, subordinated debt or loans will carry a lower credit rating and will therefore offer a higher return than senior debt.

2.     Venture Debt – Venture debt, sometimes referred to as venture lending, is a certain type of debt lending to venture-backed companies. A venture-backed company that receives venture debt is defined as companies who are at the start-up stage of their existence and rely on venture capital to expand their business. Typically the company has yet to make a profit, and loan size is usually based on the company’s recurring revenue

3.     Distressed Debt – Private credit funds are known a). for buying up corporate debt that is currently trading well under its original value and b). where companies are in difficulties to provide new financing, with a view to make a profit when the company either liquidates or restructures. 

4.     Direct Lending – This type of lending by private credit funds, (aka unitranche loans), are typically a senior term loan (first lien and the least) but can also involve credit lines and second lien loans which are subordinated to the first lien. 

5.     Special Situations –  As the subject suggests, loans in this case are applicable when a special situation or event occurs, and the company’s profitability or growth (a company’s metrics) are not taken into account when lending decisions are made.

A number of experts have asked the question: will private credit stand a sustained protracted recession? Private credit fund managers have answered that in many cases their loans are safer as they are locked in for longer than your standard lending institutions. However, the uncertainty that surrounds the terms in the private credit market means that in a recession no one really knows how far valuations would fall, and as a result would investors in funds that are struggling be able to sell out their positions. 

Regulators in the United States, the United Kingdom and the European Union are looking at expanding regulation in the private credit market. Indeed, regulators in the EU are putting strictures in place which ensure that private credit funds will diversify risk, and will cap leverage, whereby funds use borrowed funds to enhance profits. However, it appears that regulation will remain somewhat opaque as there seems to be a lack of appetite to bring regulation in line with banks and other lending institutions. This of course may reflect the attitudes of many governments, who seem happy to encourage private credit investment that they deem too risky for banks.

Interest Rate Overview: Eurozone, United States, United Kingdom February 2024

As predicted by many commentators, the governing council of the ECB (European Central Bank), the Federal Open Market Committee (FOMC) of the United States Federal Reserve and the Monetary Policy Committee (MPC) of the Bank of England, all kept interest rates on hold. All three central banks cited the continuing fight against inflation as the reason for keeping interest rates on hold, but as many experts are predicting, interest rates will fall in 2024 in all three jurisdictions.

The Eurozone

On Thursday 25th January the Governing Council of the ECB announced for the third time in a row that interest rates were being held at a record high of 4%, reaffirming their fight against inflation. Many traders and analysts in the financial markets are betting on a rate reduction at the next Governing Council meeting on April 11th, 2024. 

However, Governor Christine Lagarde announced it was “premature to discuss rates”, though some unnamed members of the council have added that if upcoming data shows that inflation is beaten, then the April meeting could be dovish for a fall in interest rates at the June meeting. Despite these utterances, many in the financial markets believe the ECB have got it wrong and will be forced to cut interest rates in April.

The United States

On Wednesday January 31st, 2024, the Federal Reserve kept policy rates at a 22 year high of 5.25% – 5.50%, where the Chairman of the Federal Reserve Jerome Powell gave a massive endorsement on the economy’s strengths. He further advised that with the on-going expectation of falling inflation, coupled with economic growth, that rates had now peaked and would fall in the coming months. However, despite this pledge, Chairman Powell went on to say that he did not expect a rate cut at their next policy meeting in March, as they wish to see on-going positive data on the reduction of inflation to their figure of 2%. 

Interestingly, the Federal Reserve is hoping to accomplish beating inflation through tighter credit without putting the economy into recession, which historians suggest they only accomplished once in the last 100 years. But with inflation falling more quickly than expected, (2.6% as at close of business 2023), the Chairman is coming under political pressure to reduce rates in March. 

A massively divided country is going to the polls in November to elect a new president, and Chairman Powel received written requests to reduce interest rates from Senator Elizabeth Warren (Dem, former presidential candidate), and Senate Banking Committee Chair Sherrod Brown (Dem). Some market experts are suggesting that there is a circa 63% chance that the Federal reserve will cut interest rates in March, but with seven weeks of economic data to come the markets will have much to mull over.

United Kingdom

On February 1st, 2024, the Bank of England’s MPC announced that it was holding interest rates steady at 5.25%, admitting that a rate cut had been part of their discussions. In the end there was a split decision in the MPC with six members in favour of holding, two members voting to increase rates and one member voting for a drop in interest rates. Interestingly, this is the first time since the Covid-19 pandemic that a rate-setter has voted for a cut in interest rates, and the first time since the global financial crisis of 2008, that there has been a three-way split in the MPC.

Following the announcement, The governor of the Bank of England Andrew Bailey announced that “the level of bank rate remains appropriate, and we are not yet at a point where we can lower rates”. He also pointed out that there is an upside risk to inflation due to continuing trade disruptions, and ambiguously advised how long policy remains restrictive depends on incoming data. However, experts suggest that the Bank of England is now warming to rate cuts in 2024, with officials believing that consumer price inflation will be at 2% in the second quarter, mainly due to falling energy prices., a year earlier than forecasted last November.

Market analysts mainly agree that whatever the statement that comes out of the above central banks, interest rates are set to fall in 2024. It would appear that the Bank of England is set to lag behind the ECB and the Federal Reserve when it comes to cutting interest rates. However, better than expected January US employment figures may delay a US interest rate cut beyond March, and as to whether or not they all fall at the same time, only time will tell.

The Growth of the Private Credit Market and the Potential Pitfalls

What is private credit and why has the  growth of this particular market been so spectacular? Looking back at the lending market as a whole, first there were the banks, then debt specialists and private equity entered the lending market, quickly followed by hedge funds and wealth managers. The private credit market really began to make its mark after the 2007 – 2009 Global Financial Crisis, when banks tightened their belts and pulled back from lending. Today, not only on Wall Street in the United States, but in all major financial centres, the buzz word on everyone’s lips from venture capitalists to sovereign wealth funds is private credit.

An explanation as to what private credit represents is where SMEs (small and medium-sized enterprises) who are non-investment grade and typically represent the recipients of loans from non-bank lenders. This market can serve as a diversifier as debt is less correlated to equity markets, and due to periodic income from repayments the J-curve is smaller*.

*J-curve – is a trendline that shows an initial loss followed by a dramatic gain, hence the j-curve.

In a nutshell private credit targets non-investment grade SMEs, and unlike private equity there is no direct management involvement. Any added value will come mostly from restructuring. The type of investments are usually direct loans which relate to senior instruments in the capital structure, often accompanied with bespoke terms and floating-rate coupons**.However, it must be pointed out that as the market has expanded so have the catchment levels, with the market catering to a more diverse base. 

**Floating-Rate Coupons – A floating rate note, commonly referred to as a FRN, is a debt instrument with a variable interest rate or coupon which is tied to a benchmark rate such as Libor (London Interbank Offered Rate) which of course has now been replaced in the US Dollar market by SOFR, (The Secured Overnight Financing Rate) and in the GBP market by Sonia, (Sterling Overnight Index Average). Many FRN’s have coupons that pay quarterly, and investors can benefit from increasing interest rates as the note adjusts periodically to current market rates.

The private credit boom has recently been driven by central banks monetary tightening policies which began in 2022 with unprecedented rate hikes over the next year to late 2023. The Federal Reserve raised interest rates ten times over in this period from a low of 0.25% to a high of 5.25%. Similarly in the United Kingdom, the Bank of England increased its key benchmark rate eleven times from a low of 0.25% to a high of 5.25%, and in Europe the ECB (European Central Bank) raised its rates seven times from a low of 0% to a high of 3.75%.

This has inevitably forced borrowers to look elsewhere to look for alternative lending sources, and the private credit market has benefited considerabley. Indeed, earlier this year in the United States, a number of mid-cap banks ran into liquidity problems, and this together with higher interest rates prompted some the more traditional lenders to exit certain business lines or unload assets. Hence, the retreat of bank lending, higher interest rates and bigger fees have brought a large number of new players to the private credit market, which has turned from what was essentially a niche market to a must-have market. 

Today the private credit market has expanded its philosophy to what has been described as a catch-all concept. Indeed, the market now incorporates traditional direct lending to the SMEs to finance buyouts, real estate and infrastructure debt. Experts advise that this will help fund managers to profit from strategies which can shield them from the volatility of mark-to market* losses in public markets. The expansion can be seen by the number of new players entering the market, such as large asset managers who are bolting on private market funds to their existing businesses or in the private equity world  increasingly using private market companies for their acquisitions. Indeed, the risk strategies employed by the new entrant private credit funds differ massively from one company to another. For example, some companies are offering high-risk mezzanine finance* to companies that are struggling, whilst mid-sized companies with fairly small or low leverage are being offered senior secured debt and private equity are being provided with funding for buy-out transactions. 

*Mark-to-Market – is an accounting practice whereby the value of an asset is adjusted to reflect its true value in changing market conditions. Furthermore, it is also where assets and liabilities are recorded at their current market value, and if a company had to pay off all their debts and liquidate their assets, mark-to-market accounting would provide an accurate value of what the company is worth at that time. 

**Mezzanine Finance – Mezzanine loans or capital can be structured either as subordinated debt or as equity, which is usually in the form of preferred stock. Mezzanine financing is recognised as a capital resource which can often be seen as subordinated debt and sits between higher risk equity and less risky senior debt. To facilitate the explanation of mezzanine debt, below are the definitions of senior debt and subordinated debt:

·      Senior Debt – often issued in the form of senior notes and also known as a senior loan, is a debt that will be paid first by the borrowing company. In other words, it takes priority over other unsecured debt and in the event the borrowing company goes into liquidation, owners of senior debt will be the first to be repaid.

·      Subordinated Debt – or as the name implies junior debt, is usually the last type of debt to be repaid. It has a lower status to senior debt and hence the name subordinated debt. Typically, subordinated debt or loans will carry a lower credit rating and will therefore offer a higher return than senior debt.

Mezzanine financing is a type of junior debt or capital and is viewed as the last stop on the debt borrowing chain or capital structure, before equity is sold in order to raise capital. Mezzanine financing allows companies to access capital beyond that of what can be accessed through senior debt. It is typically longer-term debt (7 – 8) years, and is interest only during the loan period, with amortisation at maturity. Many borrowers view mezzanine finance as “solution based” capital as opposed to permanent capital, serving a specific purpose(s), which can be replaced with lower interest-bearing capital such as senior debt at a later date.

The private credit market has increased by circa 300% in size over the last nine years, with experts valuing the market in the region of USD1.5 Trillion. Indeed, one of the largest alternative credit managers has advised that the industry could grow to the stage where it has replaced USD 40 Trillion of the debt markets. The private credit market began its life by catering to the private equity companies, and like the private equity companies they raise funds from investors. This however is where the similarity ends, as private credit lends debt to their clients whereas private equity as the name suggest invests equity in their clients.

Experts within the private credit market are referring to this boom as “debanking”, which according to one senior player is still in its infancy, while others refer to the current state of the private credit market as “The Golden Moment”. Both analysts and experts suggest that new banking regulations in the United States under proposed Federal Reserve rules will act as a catalyst for the private credit market, as the capital required to support the US wholesale banking industry could increase by as much as 35%. 

However, there are some dissenters from the regulatory arena in the United States who say that the private credit market could prove a risk to the US banking system as, unlike the banking industry, it is subject to indirect and somewhat minimal oversight. Indeed, the Federal Reserve has been requested by lawmakers as to what they, the FDIC (Federal Deposit Insurance Corp), and the Office of Comptroller of Currency were doing to address this issue. However, in a counter statement the American Investment Council trade group advised that private credit services were noy systemically risky and were quoted as saying, “ In this economy, private credit is helping small businesses to get capital to grow and succeed”.

Naysayers and detractors who say the market has grown to a point where there will be failures should not be ignored. Whatever the market, history has shown that there is always a crisis waiting around the corner. The Global Financial Crisis stands out as a case in point as does the mid-cap banking wobble in the United States earlier this year which spread to Europe and led to the downfall of the eminent Swiss bank, Credit Suisse AG. 

New entrants to the market are committing funds in the region of USD500 Million to USD1.5 Billion, despite the fact that some analysts are predicting that the market itself is coming under strain from rate hikes inflicted on economies through central bank quantitative tightening policies. Experts advise that most of the private credit investments that are outstanding as of today would have been contractually agreed eighteen months ago and would have been made against a completely different economic backdrop. 

Most private credit loans are arranged (as stated previously) on a floating rate basis, and the interest hikes over the last year could potentially have a significant effect on the performance of those companies and the funds invested therein. One expert suggests or rather confirms that the whole structure is now coming under strain. Many balance sheets of debtor companies have five to seven turns of leverage and if they had to be refinanced today then every dollar earned would go on interest payments. 

Many players in the private credit market have only experienced bullish tendencies; they have never experienced a bear market or a downturn. Recently released data shows that to date in 2023 the volume of defaults in the direct-lending market in the United States alone reached circa USD1.7 Billion. Indeed, some of the savvier participants are already hiring those with expertise in workout and restructuring including expertise in managing investments in a downturn. Market sentiment and data suggest interest rates are set to fall in 2024 – they can’t come soon enough for many in the private credit market.

China Snowball Derivatives and their Potential Losses

USD13 Billion worth of China Snowball Derivatives are approaching loss levels as the ongoing route of China’s stock market is pressurising these structured products, threatening to raise market volatility. Indeed, over the years snowballs have attracted China’s wealthy and institutional investors, but a rapid decline in the Chinese stock market is now exposing risks to these derivatives hitting loss-triggering levels. But what exactly are “Snowball” derivatives?

A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Currently, experts are advising that circa USD4.2 Billion (Yuan30 Billion) of snowballs that are tied to the CSI 1000 Index* are approaching levels that trigger losses at maturity, whilst another circa USD8.4 Billion (Yuan 60 Billion) are between 5 and 10% away from their knock-in** thresholds. This week on Wednesday 15th January, the CSI 1000 index closed at its lowest level since April 2022. 

*The CSI 1000 Stock Index – This index is composed of 1,000 small and liquid stocks of all A-shares, excluding the CSI 800 constituents (follows the 800 largest stocks by free-float market cap and represents large and mid-cap A-share stocks). It reflects the stock price performance of a group of small-cap companies in the Chinese A-share market. 

**Knock Ins – There are two types of knock-in options: down-and-in and up-and-in. The former (currently China’s problem) is triggered if the underlying asset price falls below a certain level and the latter is triggered if the underlying asset price rises to a certain level. 

During the Covid-19 Pandemic, snowballs gained in popularity among the wealthy Chinese and asset managers, with brokers typically offering such grand returns or coupon rates of between 12 and 20%. 

Between February and April 2023, many of the outstanding snowball derivatives were issued, and since then the CSI 1000 has fallen by circa 22%, and for those who bought a one year contract with an 80% knock in last February, if there is no rebound in the market, next month they may be holding some serious losses. 

Despite government efforts to kick-start the stock markets by halving stamp duty on stock trades (August 2023), or their own exchanges launching new blue chip benchmarks where sectors such as chip manufacturing or renewables are granted greater weightings, sadly for snowball holders such small measures have failed to work with many investors now looking elsewhere. Unless the government engages in the type of quantitative easing as seen in the past in Europe, the United Kingdom and the United States, there is little else the government can do to stop the pessimism that is sweeping through the stock markets, signalling losses for many snowball holders.

What is the forecast for China in 2024?

China, the world’s second largest economy, kicks off 2024 with a much weaker economy, raising doubts about the underlying foundations on which its decades of amazing growth is built. Once China’s draconian Covid-19 pandemic laws were revoked, their leaders expected it would be business as usual for their economy. However, instead of consumers returning to malls, increases in land auctions and home sales, and factories tooling up for increases in demand, foreign firms have pulled money out, factories are facing waning demand, consumers are saving not spending, two of the largest properties companies along others have defaulted on their loans and local government finances are in a complete mess.

Reforms have always been particularly difficult in China, but the leaders are now presented with some tough choices if things are to improve in 2024. However, it has been an inauspicious start as Hong Kong’s flagship, the Hang Seng Index, started 1.5% down on 2nd January 2024. Mainland China’s CSI 300, which measures the top 300 stocks listed in Shenzhen and Shanghai, also dropped 1.3% and in excess of 43% since its peak in 2021. Both indexes were two of the worst performers in 2023 with a slowdown in production activity, lukewarm consumption, a prolonged property slump and concerns over Beijing’s crackdown on the tech sector.

However it is not all doom and gloom for the Chinese stock markets. Experts say that the trends in the Hang Seng Index are closely related to the number of IPO’s (Initial Public Offerings), and the same experts are predicting that HK$100 Billion (Circa £10 Billion and $7.8 Billion) will be raised in Hong Kong in 2024, just over double of that raised in 2023. A number of analysts have gone on to say that today the risk premium of Chinese stocks has reached a level that, in the past, has led to returns nothing short of spectacular. Indeed, the yield gap between stocks and bonds has now reached circa 5.5% and has rarely been this big, in fact the dividend yield of the stock benchmark has risen above the dividend yield of the long term bond benchmark for the first time since 2005. Adding to this optimism for Chinese stocks in 2024, a well-known emerging markets equity fund in the United States boosted its equity holdings of China and Hong Kong stocks in one of their funds to 33% of its portfolio. This confirmed that, in their view, the relentless selling is just about over and 2024 will be a good year. 

On economic growth, top Chinese officials have pledged to put this at the forefront of their economic plans. However, the hole in this plan is the lack of measures to boost consumer spending, which may end up making it hard to deliver on this statement. The tone for economic development for the following year is usually set at the CEWC (Central Economic Work Conference) which finished on the 9th of December 2023. This closely watched conference announced that policy would focus on “the central task of economic development and the primary task of high quality development”. Analysts have suggested that this conference was more pro-growth than in previous conferences, however they went on to say that potential growth levels of circa 5% would be hard to achieve without stimulus measures directly targeting consumer spending. Indeed, there was a complete silence on increasing household income and consumption support policies, and many analysts agree that weak consumption is a major drag on the economy.

On the deflation front, China has been fighting this for most of 2023 due to weak spending and the property slump, and finally policymakers have indicated that they will address this problem, which up to now, has been studiously ignored. Deflation is not good for the economy as falling prices are a major concern, and companies and consumers may put off investments and purchases anticipating a further fall in prices, which in turn can further slow the economy. Acknowledging this problem a quote from the 2023 CEWC said “Total social financing and money supply should be in line with economic growth and the price target”, which basically refers to the amount of financing needed for the real economy. Analysts noted that this was the first time the Price Target had been alluded to, indicating a more accommodating monetary policy. This suggests there will be interest rate cuts in 2024 acting as a stimulus to the economy. It should be noted that the CPI (Consumer Price Index) fell 0.5% in November 2023, the biggest since the Covid-19 Pandemic, marking an acceleration in the rate of deflation. 

The property market has been a major headache for Chinese policy makers and the economy, with experts advising that property market stabilisation should be very near the top of economic priorities. This is because there are signs that the crisis within the property market is spilling over into the broader economy, including consumer confidence and financial markets. The CEWC confirmed that Chinese policymakers will meet this problem head-on by announcing the importance of resolving risks in “real estate, local government debt, and small and medium sized financial institutions”. They went on to say that the government, with regard to three major areas, will accelerate construction in public infrastructure facilities, affordable housing and urban village redevelopment. The property industry accounts for circa 30% of Chinese Gross Domestic Product (GDP), and the real estate slump has accounted for many of China’s current economic problems. House sales have gone south dramatically with developers’ debt problems spilling over into the shadow banking system*.

*China’s Shadow Banking System – This refers to financing outside of the formal Chinese Banking System and is conservatively estimated by experts to be in the region of USD3 Trillion. Such financing is made by banks through off-balance sheet activities or by non-bank financial institutions such as Chinese Trust firms. These trust companies sell investment products to qualified investors and the funds are used to invest in a wide range of financial assets, plus they are used to lend to property developers and their project companies and to local government financing vehicles who in turn lend to property companies. 

Politically, experts suggest that China’s leaders will look to thaw relations with the United States and Europe, if only for economic purposes. Indeed, President Xi Jinping met with President Joe Biden in San Francisco back in November 2023 and recently met with EU Commission officials in Beijing in an effort to keep the European Union close for trade purposes and to get access to technology. However, any perceived thaw will be down to economic expediency and nothing more. In fact, for the first time President Xi Jinping announced in his New Year speech that the economy is facing troubles in such areas as employment, with many finding it difficult to fund basic needs and enterprises having a tough time. He went on to say that we will consolidate and strengthen the momentum of economic recovery. 

Outside influences may have a direct impact on the Chinese economy in 2024. President Xi’s desire to control or unify Taiwan could put China in direct conflict with the United States. The looming presidential election in Taiwan has three candidates, the Beijing sceptic William Lei (Democratic Progressive Party), the Beijing friendly Hou You-Yi (Kuomintang)  and the third candidate Ko Wen-je who will follow the outgoing president’s approach. Beijing will look at this election as a litmus test for a non-violent unification. The possibility of a second Donald Trump term could end up being a real wild card for China/ United States relations, and could well impact some of China’s geopolitical goals. The preferred candidate for China, according to experts, would be anyone showing weakness towards NATO, Ukraine and Taiwan.

The rhetoric coming out of Beijing is setting the tone for 2024 with their ambition for progress, development and global cooperation (with the United States? We will have to wait and see) focusing on growth, sustainability and innovation, paying particular attention to the property sector. The policymakers are looking to promote long-term prosperity and stability in Hong Kong as a vibrant financial sector, as this is also essential in the rehabilitation of China’s economy. However, the property sector could really make or break China’s economy in 2024. There are many failed real estate projects in China and the crisis has also enveloped the once untouchable real estate developer Country Garden, considered by many to be a safe investment. The real worry for Beijing is a dip in housing prices, as roughly 70% of all Chinese household assets are invested in property. The government has continually fiddled with economic data, which they will have to stop in order to get more outside investment, but whilst official figures show housing prices remaining static, it is estimated that house prices have fallen by 15% in many cities and by circa 30% in Beijing.

If indeed the authorities start releasing proper economic data, and can show a credible effort at solving the property sector crisis, then according to many experts FDI (Foreign Direct Investment) will pick up as will the economy. There are many doom mongers who are saying it will be the same old China, all talk and dodgy economic data, but if those who predict a rise in the stock markets are to be believed, in 2024 China will not only talk the talk but walk the walk as well. 

 2023 Closes with Global Equities Charting Big Gains

As the financial curtain came down, marking the end of 2023, a heart-stopping rally in the last two months of the year showed global stock markets with strong annual gains due to investors betting on the fact that major central banks have finally stopped their monetary tightening policies and will indeed cut interest rates 2024. The MSCI World Index* has, since late October 2023, surged by 16%, and, with a flurry of late trading on the 29th of December, showed an annual gain of 22% . This was reflected in recent data showing that in western economies inflation is falling faster than expected, which, as mentioned above, dramatically changed the perception of interest rate changes. Indeed, Jerome Powell, Chairman of the Federal Reserve, fanned the flames of an equity rally in December by announcing that borrowing cost may have peaked.

*MSCI World Index – This is a stock index maintained by Morgan Stanley International (MSCI) and is designed to track broad global equity-market performance. This index is composed of stocks belonging to circa 3.000 companies from 23 developed countries and 25 emerging markets. 

The rise in global equities as reflected in the MSCI World Index is the best run on an annual basis since 2019, when a similar run reflected a 25% gain. The S&P 500 finished the year up by circa 24% which was mainly due to a massive rally in megacap tech stocks.  European markets, after a lacklustre 2022, posted positive gains in 2023 with Italy’s FTSE MIB charting gains of circa 30% and Germany’s DAX coming in with an impressive 20% increase. The overall increase for European equities was reflected on the STOXX 600* charting a gain of 12.6%. Elsewhere all three indexes in Japan posted hefty gains in 2023 with the Nikkei Stock average finishing the year up 28%, this being the best rally since 2013 which reflected a rise of 57%. 

*STOXX 600  Index – This index tracks 600 of the largest stock exchange listed companies from 17 countries in Europe. The countries represented are Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

The big omission from the global rally in stock markets is China, where the world’s second largest economy has suffered from problems in their property sector. As a result, the expected recovery has faltered. Indeed, China’s CSI 300, which measures the largest companies listed in Shenzhen and Shanghai, fell by 11.38%. Their flagship financial centre, Hong Kong, has suffered over the years and in 2023 stocks were particularly hard hit, with experts advising the Hang Seng index is the worst performer of 2023. 

Sadly, in the United Kingdom the FTSE lagged behind their counterparts in the United States and Europe by posting a gain of 4% in 2023. Experts suggest that this is down to a stubborn inflation rate, energy companies that are oil-price exposed, and a preponderance of mining companies that are overexposed to and rely on a slowing Chinese economy.

Many expert strategists seem to be sitting on the fence when calling the outlook for 2024. This year will determine the fate of the political leadership for half the global economy, the final battle against inflation and the fate of the current business cycle. The IMF (International Monetary Fund) has issued figures for world growth in 2024 as 2.9% with investors being excited as the IMF issued growth figures for the Asia Pacific region as 4.2%. Specifically in Singapore, Vietnam and Taiwan, analysts suggest these countries could outperform in 2024 due to the potential upswing in global tech, as they have a high concentration of manufacturing and R&D facilities. All in all many experts are suggesting a wait and see policy, as we see how the US/China relationship unfolds, the on-going ramifications of the Russia/Ukraine war, where interest rates stand in June this year, and whether or not the USA economy enjoys a soft landing.

 Final Call for Interest Rates Going into the New Year

On Thursday 14th December 2023 at the final MPC (Monetary Policy Committee) of the year, after a vote of six to three, the Bank of England maintained the status quo and left interest rates unchanged holding steady at a 15 year high of 5.25%. However, the rhetoric remains unchanged as the Governor Mr Andrew Bailey advised “There is still a long way to go in the fight to control inflation”. 

The governor further acknowledged that despite financial markets expectations, he pushed back against an expected rate cut in May 2024, as the MPC warned they may tighten monetary policy if price pressures persist. The MPC were quick to point out that the two key indicators of price pressure which are service and pay inflation remain elevated, and the United Kingdom remains the only major economy where food price increases remain in double digits, with the UK’s inflation figure of 4.7% being the highest of the G7 countries.

Across the Atlantic Ocean in the United States, on Wednesday 13th December 2023 the Federal reserve once again left interest rates unchanged. However, the Chairman Jerome Powell confirmed that the FOMC (Federal Open Market Committee) is still prepared to resume monetary tightening policies and increase interest rates should price pressures return. 

At the same time, in a more dovish stance,  the Federal Reserve leaned towards reversing their interest rate hike policies, by issuing forecasts that showed a number of rate cuts would be likely in 2024. However market experts pointed out that in November, increases in service-sector costs and in particular housing has kept inflation stubborn enough to counter any Federal Reserve interest rate cuts in the near future.

In Europe, the ECB (European Central Bank), along with their counterparts in the United Kingdom and the United States, kept interest rates on hold for the second meeting in succession. The deposit rate remains at a record high of 4%, even though inflation is heading south. The ECB confirmed that keeping interest rates high will make a substantial contribution to returning consumer price growth to the goal of 2% and they further advised that they will increase the speed of its exit from the pandemic era of stimulus which cost them Euros1.7 Trillion. 

The ECB will also increase the speed at which they are ending reinvestments under PEPP bond buying programme*, putting monetary policy tools into a tightening mode. Financial markets are expecting an interest rate cut in March 2024 despite Christine Lagardem, the ECB’s governors’, comments that policy rates will remain at sufficiently restrictive levels for as long as necessary. Markets noted with interest the wording “inflation is expected to remain high for too long” had disappeared from central bank rhetoric and was replaced with “inflation will gradually decline over the course of the next year”.

*PEPP Bond-Buying Programme – Otherwise known as the Pandemic Emergency Purchase Programme was an ECB instigated response to the Covid-19 crisis. Initiated on the 20th March 2020, it is a temporary asset purchase programme of public and private sector securities. These purchases cover sovereign debt, covered bonds (an investment debt comprising of loans that are backed by a separate group of assets), asset-backed securities and commercial paper. 

Elsewhere and outside of the major central banks, Norway increased interest rates for what is expected to be the final time with Russia also raising their cost of borrowing. Meanwhile, Mexico, Pakistan, the Philippines, Switzerland and Taiwan all maintained the status quo by keeping interest rates unchanged whilst Brazil, Peru and Ukraine all cut their borrowing rates. 

At the end of 2023, whilst the Federal Reserve, the Bank of England and the ECB all kept interest rates unchanged, it appears that the Bank of England will have a different policy to the other two central banks going forward in 2024. Whilst the ECB remains hawkish with an exit from the pandemic stimulus, there is still an anticipation of an interest rate cut in March of next year. The Federal Reserve has been more forthcoming issuing forecasts of interest rate cuts in 2024, with the most hawkish of them all being the Bank of England who are sticking by their statement that interest rates will remain high for as long as deemed necessary. However, recent data showing the UK GDP results being worse than expected may push the Bank of England into reassessing their monetary policy for 2024 forcing them into a small interest rate cut.