"I am Duncan MacLeod of the Clan MacLeod."
The Highlander film & television franchise began in the mid-1980s and ran through the late 90s. To the surprise of many critics, it spawned five movies, two television series, an animated series, an animated movie, an animated flash-movie series, ten original novels, nineteen comic book issues and various licensed merchandise (h/t Wikipedia).
My favorite film critic, the late Roger Ebert, had this to say about the 1986 film that started it all:
“[Highlander] is sort of like a garage sale at the house of a berserk screenwriter. This movie has a little bit of everything: immortality, sword fights, ancient legends, muscular heroes, exploding automobiles, wise old men, beautiful women, bloody beheadings and lightning crackling through the sky. It has an especially lot of beheadings and lightning. In fact, occasionally people’s fingertips tingle with all of the excess electrical energy in the story.” (Ebert’s YouTube review: HERE).
Despite what seemed like a promising list of Hollywood ingredients, Ebert was left underwhelmed, and gave it a thumb down. Siskel agreed, but that didn’t stop Hollywood from firing up a reboot 5 years later: Highlander 2: The Quickening, which is now generally considered one of the worst films ever made, and about which Ebert offered this:
"This movie has to be seen to be believed. On the other hand, maybe that's too high a price to pay. "Highlander 2: The Quickening" is the most hilariously incomprehensible movie I've seen in many a long day - a movie almost awesome in its badness. Wherever science fiction fans gather, in decades and generations to come, this film will be remembered in hushed tones as one of the immortal low points of the genre." (HERE).
Back to the Global Macro Grind…
Until recently, Highlander was always the first thing I thought of whenever I thought of immortality, but then I read something really interesting on Reddit.
I’ve become a big fan of Reddit. While something like a billion and a half people around the world whittle away the hours on Facebook, I prefer Reddit. Recently, this question was posed on Reddit: What is surprisingly NOT bulls**t? Here’s the one answer that caught my attention: Crocodiles actually have no life span. If they lived in a perfectly suited environment with no predators/diseases etc. they would live forever. It’s a process called Negligible Senescence. This was something I had never heard of before, and when you get to your 40s you start to feel as though you’ve seen or heard most of what’s out there.
In the simplest sense, Negligible Senescence means that a creature is functionally immortal. It means that certain types of plants or animals will not die from old age-related wear and tear. For instance, their metabolism doesn’t slow down as they get older, their heart doesn’t show signs of aging, they don’t become incompetent or impotent, they don’t lose strength or experience declining health. At the cellular level, this is because they have no post-mitotic cells – they continually undergo cellular division, reducing/eliminating the creation of damaging free radicals – this is also why these types of plants and animals never stop growing.
These organisms die only from external factors like disease or predation. Examples in the real world include lobsters, crocodilians (alligators, crocodiles, caymans), turtles, tortoises, sturgeon, and certain types of trees. For instance, Aspen trees live 40-150 years above ground, but the root system can live for thousands of years. There’s an Aspen root system in Utah called Pando that’s estimated to be 80,000 years old. There’s a bristlecone pine in Eastern California called Methuselah, which scientists peg at just over 4,800 years old.
It’s conceivable that as our understanding of genetics continues to improve – and all signs point to it improving at an accelerating rate – we may one day be able to incorporate the genetic properties of negligible senescence into our own DNA, negating most of the effects of aging. The implications this would have on investing are interesting and profound. Consider the power of compounding interest on a multi-century investible timescale. #YaleEndowmentTimescale
While negligible senescence seems like a distinct possibility for humans somewhere down the line, there’s little doubt that today the economic cycle ages and decays just as people still do. The latest evidence for this comes from Synchrony Financial (SYF), a private label credit card lender spun out of GE Capital two years ago. Synchrony is a big lender with over $65 billion in consumer receivables and counts WalMart, Lowe’s and Amazon among its customers. In other words, if you have a Lowe’s card, it’s a Synchrony card.
Synchrony fired a shot across the credit cycle bow on Tuesday by raising its guidance for expected net charge offs from a range of 4.3-4.5% to a range of 4.5-4.8%. SYF shares reacted by dropping ~14%, while the rest of the card space followed suit: Capital One (COF) was down ~5%, Discover (DFS) was down ~3% and so on.
Synchrony management presented at a conference that day and said that the problems likely went beyond just them. They suggested that consumers have suffered a decline in their ability to pay debts, and speculated that it was due to auto and student loan burdens having reached a tipping point. The increase in loss guidance of 20-30bps is small in absolute terms, and nowhere near enough to justify shaving 14% off the value of SYF, but it’s the inflection that spooked the market.
Credit trends are autocorrelated, meaning that they self-reinforce both on the way up and down, and the market gets this. The natural progression goes something like this: credit quality deteriorates slightly on the margin, lenders tighten credit underwriting in response, which causes less credit consumption, which causes credit quality to deteriorate further, which causes lenders to further tighten underwriting and so on.
In other words, once you see the first cockroach in the credit cycle, you should aggressively exterminate long exposures in your portfolio because the cycle has begun to turn but still has a long way to go. It won’t be obvious that it has turned for months or even quarters to come, but rest assured … it has turned.
Thinking back to the last cycle, there were many signs marking the turning of the cycle at various points leading up to Lehman’s collapse in September 2008. The early signs, for instance, came in mid-2005 when the rate of change in volume of homes sold began to slow. Coincidentally, also in mid-2005, homebuilder stocks peaked. By mid-2006 the rate of change in home prices began decelerating. By the Spring of 2007 subprime lender New Century went into a death spiral. In May 2007, the Financials ETF, XLF, peaked. In June 2007, two Bear Stearns Hedge Funds collapsed. In October 2007, the S&P 500 peaked. In March 2008, Bear Stearns collapsed. In September 2008, the Global Financial Crisis hit with its full fury.
I think Synchrony’s announcement Tuesday will prove to be one of the early timestamps used in the future to mark the end of the current credit cycle. Incidentally, many of the lender stocks peaked in mid-2015.
One thing to understand about credit cycles is that they’re like chains. The weakest link ALWAYS breaks first under pressure. The analog here is the subprime borrower – the person with the least resources to service their debt when a problem arises. Synchrony has sizeable exposure to subprime borrowers. In fact, 28% of their credit card customers have FICO scores below 660 – the cutoff point for subprime borrowers.
Synchrony has 65 million cardholders, which translates to roughly 18 million subprime borrowers. For reference, there are 185 million conventionally scoreable people in the US, so Synchrony’s subprime pool is roughly 10% of the total US borrower base and close to one third of all US subprime borrowers. Among big card lenders, only Capital One has a greater share of subprime borrowers at 35%.
Another thing to understand is what’s called the hierarchy of payments. Let’s say a borrower has three separate credit obligations: a mortgage, a car loan and a credit card balance. If that person finds that they’re unable to pay all these bills in a timely fashion, in which order will they choose to default? Notwithstanding the last cycle, which inverted the longstanding payment hierarchy pyramid, so-called normal cycles see borrowers first default on their unsecured credit card debt, then on their auto loan and finally on their mortgage.
Again, up until the last cycle, this is how it’s always gone. The last cycle was clearly anomalous as many borrowers chose to walk away from their mortgage while, in many cases, continuing to pay their car loans and credit cards. This cycle is not like the last cycle. This cycle will see a normal payment hierarchy. This is why seeing subprime borrowers defaulting on their credit cards is exactly what you would expect to see at the start of a credit cycle downturn.
A final thing to understand is a phenomenon called the denominator effect. Charge off rates have a numerator: the dollar amount of bad loans being written off, and a denominator: the average loan balance during the period. If the denominator is growing rapidly, this will cause the charge off rate to be artificially suppressed.
Here’s a simple example. Say a lender has $150 in charge offs on a $1,500 average loan balance. The charge off rate is 10%. But now assume that the lender grew that loan base by 50% over the past year, so the balance a year ago was $1,000. The reality is that bad loans take some time to season and they must be in default for 6 months (180 days) before they’re charged off. As such, the $150 in charge offs should really be divided by the $1,000 in loans to give an accurate depiction of the charge off rate, meaning the real charge off rate in this example is more like 15%. Once the loan growth slows, the credit quality will appear to worsen dramatically.
The point is that fast growth in receivables is usually enough to temporarily suppress the appearance of deteriorating credit quality, at least optically over the intermediate term. So the fact that Synchrony had to raise its charge off guidance at a time when it’s growing receivables rapidly means things are worsening in a material way.
In normal recessions, card lenders tend to see their shares cut in half. In the last recession, they lost 80-90% of their value. We wouldn’t expect this downturn to be on par with the last recession, but that’s not to say there isn’t still a lot of downside risk over the coming 12-24 months as cyclical senescence takes hold. The big card lenders include COF, DFS, AXP, ADS, SYF. The big banks with big card books include BAC, JPM, C. The big auto lenders with subprime exposure include SC, CACC and ALLY.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.54-1.65%
Yours in risk management,
Joshua Steiner, CFA