Good morning. The rally in stocks may have stalled in the past week or so; not so bonds. The 10-year Treasury yield is close to 4 per cent, having peaked at almost 5 per cent in October. To us, the direction of the moves is not as surprising as their speed. The volatility of long rates this year does not seem (to us) to be justified by changes in Fed policy rate expectations. Something else is going on, and we’re still not certain what it is. Send us your thoughts: [email protected] and [email protected].

A more optimistic take on the labour market

On Tuesday, we argued that there was a tension between broad signs of a significant slowdown in the economy on the one hand, and strong job creation on the other. The current high plateau for job creation — a steady 200,000 jobs created a month over the past seven months — seems likely to crumble soon. Since then, further signs of a weakening labour market have appeared. US Department of Labor data showed that US job openings fell to 8.7mm, more than half a million lower than September, a faster decline than expected; and ADP private payrolls came in lower than expected as well, at 103,000 added jobs.  

We gave what was basically a pessimistic take: the idea was that the labour market seems likely to crack before long, and once it cracks, rising unemployment could gain momentum quickly. After all, consumer spending has been the economy’s strongest support; and the most important determinant of consumer spending is employment.

But Heidi Shierholz, president of the Economic Policy Institute and former chief economist at the labour department, has a more optimistic view. She thinks that, given the totality of the jobs data (quits, openings, claims, hours worked, wages) there probably is some slowing in job creation; the apparent steadiness may be noise. But she thinks this is the pattern one would expect as an economy approaches full employment: monthly job gains and other measures decelerate. The critical point is that we are slowly approaching the rate of job gains that simply keeps pace with growth in the working-age population — somewhere in the range of 75,000-100,000. She says:

You can have a very healthy labour market for a very long time adding 100,000 jobs a month . . . and I don’t see anything that makes me think the very positive scenario of slowing to that range and maintaining unemployment at a low level; I don’t see anything that makes that unlikely.

Yes, the unemployment rate has risen from 3.4 per cent in April to 3.9 per cent in October, putting it in spitting distance of the Sahm rule, which says that when the three-month average unemployment rate has risen half a percentage point from its 12-month low, a recession has begun (on a three-month rolling basis, the unemployment rate is only up 0.3 per cent). But the entire increase, Shierholz says, is for “good” reasons: the employment/population ratio stayed steady over the period, while the participation rate rose. “Definitely not spelling concern,” she says.

Another pessimistic line of argument is that with wage inflation still at about 4 per cent and slowing gradually at best, the Fed (despite the market’s increasing certainly that cuts are coming soon) will keep policy tight long enough to increase unemployment and drive wage growth down. Not so, says Shierholz: 

The way to think about wage growth that is sustainable long term is inflation plus productivity growth. So, it’s 2 per cent inflation plus roughly 1.5 per cent trend productivity growth, which means roughly 3.5 wage growth is the target. We are basically there in recent months.

The November payroll report lands Friday morning. We will read it closely.

PC CLOs, part 2

Yesterday, we talked about private credit’s new financing instrument, collateralised loan obligations. PC CLOs are unlike traditional CLOs, where managers buy syndicated bank loans on the secondary market, bundle them, sell different risk tranches to investors and charge fees. Instead, a PC CLO is built on loans the PC shop has originated itself. Lower-risk tranches are sold to outside investors, but the equity tranche (the riskiest bit that takes losses first) is usually retained by the PC manager. It’s a way for PC to lever up before lending.

What should we make of this? CLOs are conservative structures. Their upper tranches proved safe even in the financial crisis, and their lower tranches have clearly defined risks. Because the loan payments a CLO receives flow directly to its investors, assets and liabilities are automatically matched. No marking to market, capital calls or sudden stops are involved. Many PC companies are mixing standard bank loans with CLOs, meaning a diversity of funding sources.

On the other hand, PC CLOs do represent additional borrowing, and the terms can be more aggressive. A bank would typically be comfortable lending against a private credit portfolio with a loan-to-value ratio of perhaps 60 per cent, but a PC CLO could get as high as a 90 per cent LTV, says Seth Painter of Antares Capital, a private credit house that issues CLOs.

The difference comes down to price discrimination. A bank is taking on the entire PC portfolio, and so must attach a risk premium, while a CLO chops risk into pieces and sells each bit to investors of differing tolerance. To the careful pension fund, it sells low-yielding triple-A tranches; to the risk-loving hedge fund, high-yielding double-B. In aggregate, that lets the PC CLO borrow more.

Scepticism of aggressive leverage-taking makes sense, especially when the borrowing is done out of necessity. One PC CLO manager told us that the big private credit funds “got so big that they tapped out every lending line they had. To create leverage, they had to increasingly finance their portfolios into the CLO market . . . if you have a large $10bn fund, you can only get so much credit from the banks to hit your leverage target.”

A second worry is that PC CLOs could prove weaker than traditional CLOs. PC CLOs are a borrowing tool and, given the massive influx of capital into private credit, new market entrants (or old ones scrambling for market share) could misuse it. Tactics like retaining less equity, giving the PC CLO manager a smaller stake in loan performance, would risk turning CLOs into a dumping ground for bad investments.

There is a good reply to fears of dumping bad credits on CLO investors: it just doesn’t appear to be happening. As best as we can tell, the PC shops are eating their own cooking. Nor are investors blind to the dangers: spreads on PC CLOs are priced closer to high-risk, middle-market CLOs than safer syndicated loan CLOs, notes Ivo Turkedjiev of New Mountain Capital, a private credit shop. “In practice, the market has not fully priced the difference between” middle-market and private credit CLOs, he says.

On aggressive borrowing, it’s only aggressive if the cost of borrowing from CLO investors exceeds risk-adjusted returns earned in direct lending, notes Dec Mullarkey of SLC Management. The proof of the pudding will have to be in the eating. Ultimately, the biggest risk to PC CLOs is plain old sloppy underwriting — same as the rest of private credit. Let’s hope everyone’s done their homework. (Ethan Wu)

One good read

Seymour Hersh on Henry Kissinger.

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