Sunday, 5 March 2017

Macro and Credit - Just Like Heaven

"The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism." -  Seth Klarman
Looking at the sudden jump in the Fed March hike probability concomitant with the "sucker punch" delivered in short order on Monday to the gold mining complex (making us reduce our exposure for the time being), while equities markets continuing their upward trajectory and credit their tightening bias, it made us wander this time around for our title analogy towards 1987 British band The Cure third single released and first American hit song "Just Like Heaven". Given the song is about hyperventilating and taking into account composer Robert Smith's childhood memories of mastering magic tricks, we are feeling impressed by the rapid move in markets from their hypomanic mood towards somewhat state of "euphoria" hence our chosen title. Whereas for the time being both flows and price action point towards a continuation of the rally, if indeed we are short term "Keynesian", we do remain, long term "Austrian" from a valuation perspective and that's just our "realistic bias".

In this week's conversation we would like to look at the sustainability of the rally particularly in credit from a flow perspective given in credit land since the beginning of the year and in particular High Yield, it feels "Just Like Heaven".

  • Macro and Credit - Tactically bullish, politically skittish
  • Final chart - Global expansion? This time it's different

  • Macro and Credit - Tactically bullish, politically skittish
When it comes to assessing credit, the ongoing rally in credit is supported by strong inflows into the asset class. What is questionable is the sustainable of the rally given its rapid advance. For instance, as displayed by Bank Of America Merrill Lynch from their most recent High Yield chart book for February, the year to date performance in credit and in particular US High Yield has been significant:
Cross-Asset Total Return Performance from 31st of December until 28th of February 2017 - Source Bank of America Merrill Lynch
What is of interest is that many sell-side pundits expect returns for US High Yield to be close to flat for the entire year. Yet, there has been a significant tightening in credit spreads on the back of strong inflows into the asset class as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of March 2017 entitled "Reaching for yields continues":
"It’s all about rates
Lower front-end rates have been pivotal to support flows into credit to the detriment of flows into equities. Investors continue to favour short-duration high-grade paper to insulate against steepening of curves, while outflows continue from high duration pockets.
Over the past week…
High grade funds continued on a positive trend for the sixth week in a row; and recorded the highest inflow in three weeks. High yield funds inflows remained strong for another week, now counting 13 weeks of positive flows. Looking into the domicile breakdown, as charts 13 &14 show, even though European-focused funds recorded inflows, the majority of the inflow is concentrated in US and globally-focused funds.
Government bond funds flows went back to negative territory after a brief week of inflows. Money market funds weekly flows were negative for the third week in a row. Overall, fixed income funds flows remained strong and positive for the tenth consecutive week; with more than $30bn over that period.
European equity funds flows on the other hand moved back to negative territory after five weeks of inflows. The outflow from the asset class was the biggest in thirteen weeks.
Global EM debt fund flows continued on the positive trend for a fifth week, however we note a weakening of that trend recently. Commodities funds flow remained positive for a seventh week.
On the duration front, strong inflows continued in short-term IG funds for the 11thweek in a row. Mid-term funds’ flows turned slightly positive after three weeks of sizable outflows, while flows into long-term funds remained negative for a second week." - source Bank of America Merrill Lynch
So all in all, the technical support for credit in particular and risky assets in general, in this "risk-on" environment has clearly sounded "Just Like Heaven". But, according to Société Générale in their Credit Market Wrap-up from the 27th of February entitled "Why inflows into credit do not mean spreads will go tighter", they indicate that there is no guarantee this rally could continue and therefore the ongoing tightening of credit spreads is unsustainable:
"Market thoughts
We have been bearish about credit markets this year, and so far (despite a slight widening in spreads last week) we have been wrong. In The big hangover Part II, we outlined the reasons for concern. In The worst is yet to come, we reiterated why we thought rising government yields would eventually put pressure on credit markets. Yet it is clear that most market participants are a lot more bullish than we are.
Chart 1 shows the percentage moves in spreads since the US elections. Euro IG spreads are wider (though the move occurred in mid-November). Spreads are tighter in all other markets, with US high yield leading gains, EM (either high yield or investment grade) in second place, and Euro high yield tied with the US IG market over the whole period. Note that Euro HY gains have mostly taken place this year, while US IG gains principally happened in 2016.

One of the drivers of the good performance has surely been capital inflows. In their latest Mutual Fund & ETF watch, SG’s asset allocation team note a surprising shift in the flow of funds into credit. Between the end of January 2016 and October 2016, there was a startling 40 weeks of successive inflows into US investment grade credit funds, with inflows totaling some $77bn. Then came an equally consistent 11 weeks of outflows totaling more than $12bn. Since mid-January, inflows have returned; the $5bn inflows in early February were the highest since summer 2016 and indeed one of the highest weekly totals since the data began.
Are we back to a lasting period of inflows – and tightening spreads? Perhaps, but be careful, for the flow of funds into credit is not necessarily a good pointer for how credit spreads are going to evolve from here.
Chart 2 shows the three month total of inflows into USD IG credit (in blue) and the subsequent three-month change in spreads (in red). The correlation between the two is slightly negative; what’s more interesting, however, is to concentrate on the periods where flows sharply accelerated (which we have picked out in blue).
We note the following:
  • In two of the five periods (4Q14 to 1Q15; 1Q45) rising inflows subsequently led to higher spreads.
  • In three of the five periods (late 2013-early 2014; 2Q16; 3Q16) inflows led to tighter spreads but the tightening trend decelerated.
If the inflows into credit persist, then, this is not necessarily a good sign for the market: history would, indeed, tend to suggest the reverse, with inflows met by more supply, worsening credit metrics and eventually a widening in spreads rather than a tightening. Credit investors should be careful what they wish for from here on in."  - source Société Générale.
Yet, while credit is behaving "Just Like Heaven" thanks to the supportive background of strong technicals, as we mused out recently, early 2016 was very different in the sense that the first part of the year was plagued by "bad news" from the energy sector that spilled-over to other risky asset classes and ended up "good news" performance wise during the second part of the year. We believe that 2017 could be the reverse where "good news" (technicals and fundamentals), get impacted in the second part of the year by "bad news" (additional tightening financial conditions, credit cycle turning, rise of political risk, etc.). When it comes to US High Yield and "fundamentals", the picture in 2017 is completely different from 2016 as pointed out by Bank of America Merrill Lynch in their High Yield Strategy note entitled "Let's do the limbo" from the 2nd of March 2017:
"The HY rally continues
High yield spreads tightened another 26bps for a 1.21% excess return in February, the 8th consecutive month of spread tightening. Although all 18 sectors finished in the green, performance across industries varied with Health Care (+3.40%) and Telecom (+2.97%) leading all others. The former outperformed due to alleviated concerns surrounding changes to the ACA, while the latter delivered strong returns because of M&A speculation amongst two of the largest capital structures in the index (S and INTEL). On the opposite end of the spectrum, Energy was the worst performing industry with a +0.36% gain, just the 2nd time the sector has underperformed the overall index in the last year (Note: we lowered over view on Energy from overweight to market weight back in January). Although valuations have certainly become stretched across high yield as we are now just 39bps away from the post-crisis tights, we think this trend can continue (albeit more slowly) as it has come against a backdrop of improving fundamentals and a declining default rate, which we discuss below.
 Q4 fundamentals first take: sustained improvement
With roughly 70% of our HY universe having reported Q4 earnings, so far top and bottom line growth have continued to trend higher. Notably, HY revenue continued to improve for the 4th consecutive quarter; in fact, the current +5.0% growth represents the first YoY increase since Q4 2014. The same story holds true ex-Commodities, where revenue growth increased from +3.3% in Q3 2016 to +5.7% last quarter. And because EBITDA growth outpaced modestly higher debt levels, leverage continued to decline while coverage ratios increased.

Although these figures remain better than their historical averages during ‘normal’ times, the recent trends should act as a token of optimism for investors. Within sectors, these preliminary earnings results show the strongest YoY gains in Gaming, Capital Goods, and Retail. On the other hand, Food and Health Care have experienced the largest deterioration in EBITDA on a year over year basis.
Default rate sees largest 1 month decline since 2010 
The US HY default rate fell from 7.06% last month to 6.11% today; this 95bp reduction is the largest 1 month change since August 2010, when the rate fell from 4.25% to 2.97%. There was a noticeable lack of filings last month, where for the first time in over 2 years there were 0 first time defaulted issuers1. However, also driving the default rate lower was the removal of February 2016 from the trailing 12 month rate, where we saw 10 unique issuers default. Although the reduction in Energy defaults is responsible for most of the decline, on an ex-Commodity basis the default rate still ticked lower, from 3.3% to 2.9%. These drops are consistent with our view for a lower default rate in 2017, where we expect the rate to decline to just 4.0% for US HY issuers and remain at 2.9% ex-Commodities. With just 5 defaults YTD, this would imply an additional 31 defaults in 2017 (20 ex-Commodities)." - source Bank of America Merrill Lynch
While looking at the High Yield default rate is like looking at the rear view mirror, the most noticeable change in terms of fundamentals between 2016 and 2017 has been EBITDA YoY percentage change as per the below chart from Bank of America Merrill Lynch High Yield chart book:
- source Bank of America Merrill Lynch

Some would rightly ask if this "Just Like Heaven" picture would be distorted by the Energy sector, it isn't as per the chart below:
- source Bank of America Merrill Lynch

What matters for default rate going forward is the evolution of lending conditions. As we have mentioned recently the noose is already tightening for Commercial Real Estate (CRE), but we have to see a meaningful deterioration overall, spilling over to the default rate as per the chart below from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

Yet, while the picture seems rosy, in fact "Just Like Heaven", given our fondness for monitoring credit conditions to assess the credit cycle, we have noticed that since the beginning of the year in the US Commercial and Industrial Loans (C&I) have turned "South". The chart below from Bank of America Merrill Lynch illustrates the latest trend:
- source Bank of America Merrill Lynch

Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth).

While markets so far seems oblivious to political uncertainties building up and remain tactically bullish, political uncertainties particularly the mess in France could throw in short order a spanner in the works, hence our cautious "optimism" or short term "Keynesian" bias. In relation to French elections and us being French we would like to give you our opinion on the matter. After all, we got Trump and Brexit right in 2016, but, when it comes to having a clear view on the outcome, we must confess we do not have one. It is probably the first time since 1958, that French elections represent such a "known unknown". One would think pundits would have learned from making inaccurate predictions after an eventful 2016 which saw BREXIT, Trump's elections and the Italian referendum. The odds of Marine Le Pen upset in the second round has to be taken into account, particularly given that the second round occurs on Sunday 7th of May and the Monday is a holiday. People might decide they have other things to do than show up at the poll stations. Bear that in mind. Whoever gets elected on the 7th of May doesn't resolve the uncertainty for France given that a month later you get the parliamentary elections for the national assembly. All in all, France is a very big mess. 

As things stand, global expansion in this particular credit cycle has seen volatility subdued, but, given the gradual pull back from accommodation from central bankers, one would think there is a heightened probability in seeing a regime change in terms of volatility regime. We think the second part of the year could mark this change. In our final chart below, we will briefly discuss the relation between global expansion and lower volatilities.

  • Final chart - Global expansion? This time it's different
Though the macro data seems to be pointing towards an acceleration in global expansion, volatility continued to be subdued, yet political uncertainties keep rising on a daily basis. Our final charts comes from Nomura FX Insights note from the 3rd of March entitled Le Pen and the lessons learnt for FX Vol" and shows that global expansion has led to lower volatilities, yet this expansion, in the ongoing credit cycle has been very different from the past:
A global expansion has historically meant lower FX vols overall, but ending unconventional monetary policy could be the exception to the rule
Historically, when we have entered into a global expansion phase as we expect (see Catch-up expectations and Back to boom/bust?), we tend to see FX vols head below their long-term averages (see The Great Moderation of 2014).
While this is perhaps true for equity vols, it could be different this time for rates and therefore FX vols. The US expansion is entering its seventh year of growth, which is already the fourth-longest expansion we have seen since the late 1940s (Figure 1) and on some metrics is looking rather mature already.
Big questions remain on the outcome of the geopolitical risks, but also what impact on markets the years of unconventional monetary policy will have when it comes to an end. We studied the impact of the zero lower bound (ZLB) on fixed income and what happens at times of lift-off, where we found term premia in fixed income markets can increase in a non-linear fashion (see Lift-off, term premia and exchange rates). With the risk of a sudden non-linear increase in interest rates as the ECB and other central banks look to exit unconventional monetary policy the “post Trump” sell VIX / Buy MOVE trade still looks like it will remain at high levels (even though we already hit our target, see Top Trump Trades).
So while equity markets continue to exhibit strong optimism for global growth, in fixed income it may not be such a smooth ride, given the removal of monetary policy stimulus, which could also have a feed-through impact on FX vols on a general basis." - source Nomura
When it comes to changes in the volatility regime, for now it's "Just Like Heaven", but, maybe the road to hell is paved with European elections? Who knows...

"Fragility is the quality of things that are vulnerable to volatility." -  Nassim Nicholas Taleb
Stay tuned!

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