War and political upheaval dominated the headlines, but financial markets spent the second quarter partying like it was 1999. In their latest quarterly Market Observer, the team at Canso Investment Counsel Ltd., a leading Canadian institutional investment management firm, raised the alarm about what they bluntly described as an idiotic level of risk-taking, downward-spiraling credit conditions, a slowing economy—and the potential for the current “market balloon” to come crashing back down to earth.
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What, me worry?
The July Market Observer—published just a couple weeks before the global equity market meltdown of Aug. 5—began by noting the reality that the world has been in a state of “political and social tumult.” The Canso team pointed to the wars raging in Ukraine and Gaza; to a historic change in government in the United Kingdom; to the rise of “conservative right-wing and anti-immigration policies” in other Western democracies; to the “fractious coalition government” likely to emerge in France; to “the strains on the American judicial and political system from the Biden/Trump presidential rematch”—further marred by the attempted assassination of Donald Trump on July 13—and even to politically sleepy Canada, where the country “seems united in its feeling that the Trudeau government has passed its Best Before date.”
And yet, through all of this upheaval, “financial markets are still dancing to the continuation of their own tune ‘Up, Up and Away’ in their beautiful market balloon,” continued the newsletter. Assets had been “literally priced for perfection” in the face of not just sociopolitical volatility, but also the highest interest rates in years. Markets, the team wrote, seemed “in denial that anything could go wrong” and “expect[ed] their friendly central banks to rescue them from their financial foibles if anything actually does go wrong.”
Land of Confusion
The Market Observer noted just how wrong financial experts, central bankers and investors have been historically. Inflation that was thought to be “transitory” three years ago turned out to be very sticky indeed. When central banks hiked rates to fight it, the experts—and the inverted yield curve—predicted a recession that has never come (yet). Even the vaunted Dot Plot of the U.S. Federal Reserve’s Open Market Committee (FOMC) “has been way off in its predictions,” the Canso team wrote. “ FOMC predictions of future interest rates have been no better than random and have stoked investor confusion.”
The bond market has proven itself at least as bad at forecasting rates, as Canso’s analysis of expected yields illustrates. Two years ago, the Canadian expected yield curve predicted long bond rates that were lower than they turned out to be by 0.25 per cent—and the curve was even more wrong in the short end, where it undershot actual by 1.7 per cent. At the end of June 2023, meanwhile, the expected yield curve indicated long rates that turned out to be 0.5% higher and short rates that ended up 0.7% higher than forecast. In short, the Canso team concluded, “the bond market is a terrible predictor of interest rates, largely because it is the summary opinions of frail humans.”
Since 2023, expected short rates have moved down and long rates have moved up, perhaps suggesting that the Canadian bond market “is finally coming to a grim realization that the happy days of Zero Interest Rate Policy (ZIRP) are well behind us,” the newsletter added. The problem, however, is that long rates might still have plenty of room to go up. When the Canso team looked at long-term average real yields (nominal yield minus inflation at a perhaps optimistic two per cent) on long bonds, they found that real yields are still “low by historical standards, excepting the period of ZIRP madness.”
That, the Canso team wrote, “would very much catch the bond market offside.”
A dangerous thirst for private debt
In this context, the recent enthusiasm for private credit had Canso downright alarmed. Those at the firm have invested in private debt (along with every other fixed income asset class) for four decades, and they wrote that they have “never seen a market with weaker lending standards than the current ‘Private Debt’ mania.”
The Market Observer noted that as private credit funds have increasingly become retail products and grown into a US$2.1 trillion industry, some of the firms “‘lending’ the money aren’t really lending their own money.” A Bank for International Settlements (BIS) study recently found that 40% of private credit funds have none of their own capital invested in them—creating what the BIS calls an “incentive misalignment.” The BIS also found that most (78 per cent) private debt issues are financing levered private equity transactions, and that only 40 per cent of private debt managers use third-party pricing.
The result is “quite an incentive for sponsors to ignore the negatives,” wrote the Canso team, who offered their own description of the state of private credit markets: an “opaque cesspool of lousy loans to some of the greediest and self-interested people in the world.”
They also noted that many private debt issues are being transformed into Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs), which “slice and dice very sketchy loans into ‘tranches’ of varying credit quality.”
Take cover
Canso’s focus now is on capital preservation. The team wrote that the potential for the economy and markets to get much worse is very real.
Asset valuations have been inflated after years of easy money and credit that have encouraged risk-taking “idiocy,” as the Market Observer called it. The historically huge money supply created by central banks and governments during the pandemic still has a long way to come down despite higher interest rates, meaning inflation might not be dead yet. Meanwhile, those higher rates have been showing signs of slowing the real economy—consumer spending power, the newsletter noted, might be finally running out, and the U.S. job creation machine seems to have stalled. The Canso team expects loan losses to soar. “We are only now finding out,” they wrote, “how bad things are as the monetary tsunami flows out the other way.”
This story was created by Canadian Family Offices’ commercial content division on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.