Credit - Mack the Knife

"Oh the shark has pretty teeth dear,
And he shows them pearly white
Just a jack-knife has Macheath dear
And he keeps it out of sight." - The Threepenny Opera 1954

Watching with interest the on-going carnage in the commodity space in conjunction with the current sell-off in US High Yield in true "convexity" fashion seeing significant fall in cash prices at a rapid pace spelling the return of strong deflationary forces, we reminded ourselves of Mack the Knife, a song composed by Kurt Weill with lyrics by Berthold Brecht for their music drama known as "The Threepenny Opera". Mack the Knife is a "moritat", a murder ballad, from mori meaning "deadly" and tat meaning "deed".  In a "moritat", the lyrics form a narrative describing the events of a murder. In our case, we are witnessing the "murder" of the commodity sphere. The murderer is indeed "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

Of course what is happening in the commodity space as well as in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:

"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisisIf the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

It might not be a "last tango" but, it looks more and more to us as "Murder ballad" à la Mack the Knife. Therefore, in this week's conversation we will look at the significant ripple effect "Mack the Knife" aka King Dollar is having on the EM tourists and carry players alike in his murderous ballad.

Synopsis:

• The return of Gibson's paradox and our "macro osmosis" theory are playing out
• Hypertonic surrounding in Emerging Markets prevents them from stemming capital outflows - the case of China
• High Yield and the scary CCC credit canary
• For High Yield, default matters particularly with contagion risk from commodity
• EM credit spreads and oil prices are highly correlated
• Final chart: Big gap between debt and equity

• The return of Gibson's paradox and our "macro osmosis" theory are playing out

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates, we will simply look at the relationship of the return of Gibson's paradox with an illustration provided by Barclays from their most recent Commodities Weekly note from the 27th of July entitled "The collapse continues":

"Gold as a currency: Macro headwinds
Gold can be viewed as a currency and its price is affected by three main factors: the real interest rate, US dollar strength, and safe-haven demand. We believe that the real interest rate is the most important macro factor for gold prices. Figure 1 shows that, empirically, the US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. 

We are near the beginning of the rate raising cycle and our economists expect the Federal Reserve to have first rate hike in September. The rate hike expectation is likely to continue weigh on gold prices.
Gold is unlikely to gain any support from the dollar or safe-haven demand either, in our view. Our FX team continues to think that the dollar will strengthen (Global FX Quarterly: In the dollar we trust , June 2015), which is negative for gold. Two main risk events, the Greek crisis and the Chinese stock rout, have entered a calmer phase, implying limited safe-haven demand.

Gold as a commodity: Where does the gold go?
Monday’s sell off follows lower-than-expected Chinese central bank purchases data, which turned people’s attention to the gold physical balance sheet. Figure 2 plots total fabrication demand against three main channels of physical gold supply: mine production, scrap, and central banks’ selling.

Global fabrication demand has declined the since mid 1990s and there is a sizable gap between physical supply and fabrication demand since 2000, even with central banks gradually becoming net buyers." - source Barclays

Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

• Hypertonic surrounding in EM prevents them from stemming capital outflows - the case of China

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits. 

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). On that note we read with interest Bank of America Merrill Lynch's China in Focus note from the 29th of July entitled "Capital outflows: how to measure and what to watch":

"We estimate China’s capital outflows widened to US$92bn in 1H15 from US$30bn in 2014, and the pressure could continue in the near term. While some capital outflow is unlikely to harm China’s external position materially, careful liquidity management is required for growth and market stability. There is ample policy room for further RRR cuts and targeted liquidity injections, and we believe the PBoC will take necessary actions.

Capital outflows: how to measure and what to watch
Market concerns about China’s capital flight are on the rise. In our view, capital flow conditions are becoming more volatile in 2015, and outflow pressures could rise in 2H15. Externally, the likely Fed rate hike and continued USD strength could result in capital outflows from emerging economics including China. In China, relatively weak market confidence in CNY-denominated assets amid the recent stock market turmoil and talks of potential CNY-trade band widening may lead to bigger RMB depreciation expectations. Beyond the short term, with China’s more balanced but still positive current account and policymakers’ FX reform efforts towards a more flexible CNY and less FX intervention, a small deficit of capital and financial accounts could be the new norm for China.
Some capital outflow is unlikely to harm China’s external stability materially, due to China’s sustained current account surplus (~2.9% GDP in 2015), low foreign debt (15% 2015 GDP) and large FX reserves (US$3.7tn at end-2Q15).
However, it’s necessary for the PBoC to manage domestic liquidity condition carefully to avoid possible RMB liquidity drain when economic growth momentum is still soft. It has a big room to inject liquidity by cutting RRR, which is currently at around 18.0%, if capital outflow risks the stability of interbank liquidity and base money supply. Other measures may also be taken to improve liquidity and credit supply for the real economy such as medium term lending facility (MLF) and pledged supplementary lending (PSL). We expect the PBoC will continue opening up China’s capital account in a controlled and prudent manner to manage capital-flight risks.

Measuring capital outflows: US$92bn in 1H vs US$30bn in 2014
We estimate that capital outflow could be around US$102bn in 2Q. In 1H15, it could be US$92bn, widening from US$30bn in 2014. As such, the total capital outflow since the start of 2014 could be US$122bn, far lower than some of the popular estimates in the markets. We take a simplified approach, described in “Estimating China’s capital flow and estimate”, 8 April 2014, to roughly estimate a “portfolio and other unexplained capital flow” to capture the “hot money” nature of some cross-border flows. In a nutshell, we take the change of the
FX purchase position and FX deposits as the aggregate inflow, deducting flows by trade surplus in both goods and services and net inflows of direct investment from the aggregate inflows, leaving the remainder as portfolio and unexplained capital flow. Moreover, we adjust for the impact of RMB international trade settlements.
Why some popular estimates exaggerate capital outflows
In comparison, a popular estimation method would be taking the difference of change in FX purchase position and current account balance and net FDI. However, as we pointed out in our previous reports, this measure could significantly exaggerate the magnitude of capital outflows when the market expects RMB depreciation. This is because: (1) it fails to take into account the impact of currency choices for trade settlement with RMB trade settlement facilities on FX purchase and FX reserves, which could in turn lead to overestimation of capital outflow. More foreign exporters would demand USD payment while foreign importers may pay for goods with RMB, resulting in lower FX purchases; and (2) it overlooks the increase in domestic banks and other institutions’ FX holdings, which will lead to a drop in FX purchases without capital flowing across the border.

Capital flow indications
To gauge capital flow momentum on a high-frequency basis, we could monitor the following two sets of data for some clues. First, we could track the trend of CNY/USD appreciation/depreciation expectations and USD strength. When CNY/USD depreciation expectation rises or USD strengthens, there will likely be more pressures on capital outflows if other macro factors remain relatively stable.

Second, RMB asset performances matter too. While a complete data set on cross-border portfolio investment is not available, we could watch net inflows/outflows under the Shanghai-HK stock connect for some indication of portfolio investment sentiment.

 - source Bank of America Merrill Lynch

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates).

• High Yield and the scary CCC credit canary

Of course we were way in advance in sounding a warning on that subject in our conversation "The False Alarm" in October 2013 where we stated:

"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics

We will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

Our cause for concerns has been validated recently given the on-going sell-off in the US High Yield bond markets. On that subject we read with interest UBS's take in their Global Credit Comment from the 27th of July entitled "The scary reality":

"High yield: The scary reality
The current sell-off in US high yield bond market appears controlled based on the consistent but moderate declines in daily cash bond index prices, but underneath the hood several participants are characterizing the price action as carnage. At an index level the average HY bond has fallen about 2 points week-over-week, but index data is notoriously stale and lagging; there are numerous examples of issues down 5, 7 or 10 points on light volumes despite no direct exposure to commodity prices and no material firm specific news. In our view, recent market behavior has exposed several hidden fragilities in the market ecosystem.
First, too many investors were overweight heading into the sell-off, in particular in the energy complex. The plunge in oil and commodity prices following the Iran deal and Chinese demand fears has intensified the potential fundamental stress in resource related sectors, and this outcome was not anticipated by the consensus. Anecdotally we've heard several credit funds have raised cash balances, but there are two problems with this thesis: one, the rise is arguably structural as outflow risks rise in an environment of tighter monetary policy, rising credit risks and lackluster performance. Two, many of those who raised cash we believe added beta to continue producing above-benchmark returns and limit tracking error. This strategy fails in a decompression scenario where low quality and illiquid credit underperforms.
Second, the sensitivity of energy firms to oil prices is not linear anymore- at depressed levels what would be considered 'normal' levels of commodity price volatility can have outsized effects on fundamentals and market prices. Simply put, the risk symmetry in stressed sectors is to the downside for bondholders. The rub is central bank quantitative easing drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, loan and emerging market debt to satisfy yield bogeys. The problem, however, is some of the tourists underappreciate the exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle turns annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range (versus $83 currently) - especially given expected recoveries average in the $20 - $25 context. The scary reality is those investors in triple Cs are seeking high single digit returns when they are likely to end up with negative total returns over the next several years (if our view of the credit cycle proves correct).
Third, the perceived illiquidity in the marketplace at present is due not only to seasonal and month-end effects as well as regulation; the phenomenon also has its roots in uncertainty bred on information gaps and asymmetry. It is well known that the overall HY market has doubled in size; sectors that witnessed more buoyant issuance in recent years like energy and metals mining have seen debt outstanding triple or quadruple. And the number of new names and issues has grown a commensurate amount. The reality is that resources in many segments of the market have not kept up.

Simply put, the growth of the credit markets have not been matched by the addition of research resources (e.g., credit analysts) in many of the silos. Global banks are an obvious example, but a quick graph of employee growth across US banks, brokers, asset managers and rating agency types illustrates the reality that some investors have not added the resources necessary to do the fundamental credit work for today's bloated HY market (Figure 1).

Admittedly employee growth is not shown for the HY credit businesses specifically; however, anecdotes are plentiful enough. For example, high yield managers with one energy analyst responsible for covering 200bn in debt outstanding across 300 issues, or total return funds that bought energy in Q1 which have no dedicated credit research team- only a couple credit PMs/ generalist analyst types.

This would not be a problem if street and rating agency resources were adequate. But they are simply not. The overwhelming majority has been swimming in the opposite direction; nearly all sell side analysts have been asked to cover more names with less support, and the dynamic is similar at rating agencies. In our view, this is a problem as the smaller issues pose more significant credit risks. For example, splitting the overall HY index universe by issuer size (greater, less than 1bn in total debt) we find a considerably higher concentration of single B and triple Cs among the smaller issuers (Figures 2, 3).

And we observe a similar dynamic for the energy and metals/mining segments (Figure 4, 5).

Moreover, the small issuer cohort still accounts for one-quarter of the total HY index universe. In summary, the lowest of the junk rated bond market pose more elevated default risks- yet this cohort is where there is less research coverage, fewer banking relationships, limited trading volumes and very little liquidity. And when defaults start rising some of the tourists may not have the resources necessary to explain the losses in their portfolios when their proverbial shoulders get tapped." - source UBS

Indeed, not only have the macro tourists been "carried away" and are becoming easy preys for our "Mack the Knife" but, High Yield tourists, particularly in the CCC bucket will as well face at some point the jack-knife of our murderous "beta slaughterer", yet another unintended consequences of higher regulatory pressure and dwindling liquidity. Make no mistake, during the next credit downturn, you can expect much lower recovery values, making CDS 40% recovery value assumption for senior debt dubious at best. Negative convexity of callable High Yield bonds is enhanced during sell-off periods and not only does a bondholder suffers from mark-to-market loss but also has to contend with a higher duration investment in most cases as he reaches out for yield and seeks outperformance of his benchmark.

As a reminder, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger. And, as per our "Blue Monday" conversation earlier in July, convexity has started to bite credit in earnest:

"Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space" - Macronomics, 4th of July 2015

• For High Yield, default matters particularly with contagion risk from commodity

When it comes to the murderous spirit of our "Mack the Knife it has been more akin to a serial killer working overtime when it comes to the significant price movement seen in the High Yield energy and basic material sectors. On the murderous impact of "Mack the Knife" on the sector, we have read with interest CITI's take in their note from the 30th of July entitled "What Credit to Buy if You're Bearish":

• Overview — Bonds in the HY energy and basic materials sectors are down as much as 27 pts this month, but despite lower levels credit investors seem more biased to sell than buy. In this article we first outline fundamental and technical reasons to be bearish in the period ahead. Of course, most PMs have to hold something in these sectors, and in this regard we also introduce a framework for quantifying the risk / return profile of various issuers.

• Fundamentals Prospects — Near-term, we are bearish on the fundamentals.

• There are a number of factors that will weigh on underlying commodity market fundamentals, ranging from falling shale well costs to higher rig counts. Fundamentals for specific issuers in the energy and basic materials sectors face a variety of challenges, as evidenced by the fact that the stock price for 12% of our sample set now trades below $1.

• Technicals Prospects — Flow and positioning data suggest that the technical backdrop could exacerbate any negative fundamental developments."

 - source CITI

When it comes to the High Yield energy sector and Basic Materials, "Mack the Knife" has indeed been very swift with his blade.

But, for High Yield valuations default risk matters and matters a lot. High Yield is a more default sensitive asset and given the "murderous" impact of Mack the Knife on the commodity sphere, there is indeed a default risk spillover in the High Yield sector according to UBS from their 30th of July Global Credit Comment entitled "Credit contagion: why commodity defaults could spread":

"Credit contagion: why commodity defaults could spreadIn the wake of the commodity price swoon one of the recurring questions is will the stress in commodity markets spillover to other sectors? We have already noted some tentative signs that the selloff is beginning to spread as HY energy contributed less to the overall HY market widening last week (12% vs 53% from Jun 3 - Jul 20). However, a few weeks does not make a trend. To answer this question we revisit our outlook for potential defaults in the commodity sectors and discuss the primary channels of plausible contagion to the broader market.
First, regular readers will recall our HY energy default forecast of 10-15% through mid-2016. Simply framed, the commodity related industries total 22.8% of the overall HY market index on a par-weighted basis. In our view, sectors most at-risk for defaults (defined as failure to pay, bankruptcy and distressed restructurings) total 18.2% of the index and include the oil/gas producer (10.6%), metals/mining (4.7%), and oil service/equipment (2.9%) industries. Within these three B/CCC exposure in these industries comprise 10.2% of the index (6%, 3% and 1.2%, respectively). In our view, defaults in the B/CCC categories would be severe at current commodity prices; roughly 25% default rates annually for this cohort seems reasonable given past precedent and a sanity check from our single name specialists. A few investors have suggested our projections may prove conservative as distress could reach some of the higher-quality (BB) issuers in the at-risk sectors given structural/cyclical headwinds.

With that said, how large are contagion risks to the broader HY market? And what are the transmission channels? Historically, investors in the limited contagion camp would probably point to the early 1980s. In this cycle commodity price defaults spiked with the drop in oil prices yet average default rates (IG & HY) increased only moderately amidst a favorable economic environment. In our view, however, the parallels in terms of the credit and asset price cycles are a stretch versus the current context. In the last three cycles, commodity price defaults have either led or coincided with a broader rise in corporate default rates (Figure 2).

More broadly, we find high degrees of correlation between industries with above and below average default rates (e.g., the 25th and 75th percentiles) since the early 1990s (Figure 3).

 

And, not surprisingly, associations between HY spreads in the lower and upper quartiles also appear quite robust (Figure 4).

But why should there be contagion from commodity sectors to other segments?
Academic literature offers up a host of plausible theories. There is a clear pattern of default correlation dependent on fluctuations in national or international economic trends. Commodity price weakness is symptomatic of weak economic growth in China and emerging markets – with possible spillover risks for commodity related sovereigns (oil exporters) and corporates.

In addition, distress in one sector affects the perceived creditworthiness as well as profits and investment of related firms in the production process. For example, exploration and production firm defaults could negatively affect suppliers and customers which would include oil equipment and service, metals, pipeline, infrastructure, and engineering firms.

Furthermore, related literature points to the significance of the supply/demand balance for distressed debt; our theory is that there is a relatively finite pool of capital for distressed assets, implying greater supply of distressed paper pushes down valuations of like assets. Unfortunately, a rise in the supply of stressed bonds typically coincides with a decline in demand for such assets. This self-reinforcing dynamic historically leads to a re-pricing in lower quality segments. Moreover, regulation and market structure increase the risk that investors will absorb fund outflows and mark-to-market losses by selling similar assets if liquidity in stressed issues dries up. And finally, one of the looming technical risks for HY credit markets, in our view, is fallen angels; there is about $400bn of BBB- and $400bn of BBB rated debt outstanding in US high grade indices, of which 30-35% is energy related and much of it is longer duration. In summary, we believe the evidence argues strongly in support of the thesis that commodity defaults could cause broader HY default and spread contagion. So for those in the decoupling camp, you've gotta ask yourself one question: "Do I feel lucky?"" - source UBS

When it comes to High Yield, it looks indeed that Mack the Knife's jack-knife blade while still
out of sight is ready to strike our "credit/macro" tourist in earnest...but we ramble again...

Not only US High Yield and Investment Grade in commodity sectors are at risk but EM credit spreads are also in the target line given the correlation between EM credit spreads and oil.

• EM credit spreads and oil prices are highly correlated

Given the exposure of some sovereigns and quasi sovereigns to the oil sector it doesn't come as a surprise to see additional pressure not only in the FX sphere but as well on EM credit spreads to the evolution of oil prices. This relationship is clearly highlighted in CITI's EM Strategy report from the 29th of July 2015: 

"EM credit spreads and oil prices are highly correlated — Given the renewed collapse in Brent to levels below $54, broad EM corporate spreads should widen a further 10-30bps on top of the 10bps of widening over the past three weeks. Obviously, credits directly involved in the oil business should experience greater widening. Tight market technicals and poor liquidity may prevent this from being fully materialized.

Commodities bite EM again, while Brazil gets kicked around a bit more
The week began with another leg down in commodity prices, combined with heightened anxiety about Brazil’s status as an investment grade credit. We see the two dynamics as being interrelated, as Brazil, while diversified across its commodity basket, very much remains a commodity dependent economy and is highly subject to the polar vortex hitting markets at the end of the commodity super cycle.
We maintain that oil prices are the most important commodity driving EM credit, given that oil is the largest sector by issuance after financials, and it is the bellwether commodity in the world. For EM specifically, iron ore and copper are also important commodities. In figures 3-12, we update and expand the charts we published on July 6 in our Oil tumble a bigger concern than Greece report. In that report we recommended to buy on weakness if Brent prices fell below $60 and broad EM spreads widened by 20-40bps. 

They have widened by only 10bps, so we see another 10-30bps of widening needed to abide by our original recommendation before buying should commence. Given the greater than anticipated drop in oil, as well as the negative ratings actions in Brazil, we believe the wide side of this range should be reached at the least." - source CITI.

Of course when it comes to correlation with oil prices and as shown in CITI's report EM currencies have been first in the line when comes to feeling the heat from falling oil prices:
"EM currencies remain highly correlated to oil

EM currencies are much more liquid than hard currency debt, and therefore reflect price movements fairly quickly. We can see this in figures 11-12. 

The point we are making here is that weaker currencies can offset some of the commodity price pressures oil and mining credits are experiencing. In several past reports that focused on Brazilian and Russian corporates, the main commodity producers in EM, we showed through our scenario analysis that weaker currencies tended to benefit the export sector. PETBRA, as usual, was the exception, given its BRL priced gasoline policy.

Our Broad Recommendations
We believe broad EM corporate credits spreads will cheapen out another 10-30bps because of the price oil until we would come in and buy. For Brazil, we anticipate its corporates will be negatively impacted by any potential downgrade and anticipate 50-75bps of relative spread widening as they converge with Russia. We do not believe this move is fully price in despite recent weakness. Russian corporates have lagged the move down in Brent while the RUB has done much to offset the decline in commodities and have kept the country competitive. We doubt this can be sustained, and if Brazil overshoots Russian spreads, we believe Russian corporates may re-correct back to Brazil. Of single name credits, PETBRA bears mentioning as being at risk of downgrade by S&P as the agency has already stated PETBRA remains IG due to implied sovereign support. As we mentioned last week, we believe Brazil’s subordinated bank debt from BANBRA, BRADES and ITAU is subject to a ratings downgrade. We continue to dislike iron ore as a sector." - source CITI

Looks like Mack the Knife has indeed a little more to carve-out from the already wounded EM crowd and its macro tourists cohort....

Whereas credit and in particular High Yield has been weakening, there is indeed a growing disconnect between equities and debt markets.

• Final chart: Big gap between debt and equity

Whereas last week we pointed out the growing disconnect in terms of flows in both asset classes, there is a well a growing disconnect between high grade credit spreads and equity volatility which continues to be subdued. This has been clearly pointed out by Bank of America Merrill Lynch in their Situation Room report from the 28th of July entitled "Equity meet debt, debt meet equity":

 "Equity meet debt, debt meet equityGiven the large disconnect between the two markets we thought we should make the introduction. Over the past roughly three months (since April 22st) high grade credit spreads from our bond index have widened 23bps, or about 18%, while equity volatility has declined 1 percentage point, or approximately 6% (Figure 1). 

While already a sizable gap notice that the underlying pricing in bond indices tends to be rather stale – thus we point out that a basket of spreads for a limited number of liquid 10-year non-financial, non-energy, nonmaterials bond spreads we track has widened 39% over the same period of time. While from a theoretical perspective credit spreads and equity volatilities are comparative measures of risk associated with a given company when capital structures are constant, clearly they are now sending vastly different messages. This difference in perspectives measured from different parts of the capital structures may reflect a number of factors including differences in sector composition of the two markets, different horizons, changing correlations, expected re-leveraging associated with the acceleration of the M&A cycle, etc.

However, clearly most of the difference between the messages sent by the debt and equity sides results as the former asset class has begun to price in the coming Fed rate hiking cycle. As we discussed in our weekly piece (see: Policy matters) that re-pricing took place in part as issuers accelerated supply ahead of Fed liftoff, and as deteriorating returns significantly reduced retail demand. That leaves HG credit spreads around the cheapest level relative to equity vol we have seen outside the financial crisis (Figure 2). 

Obviously either market could be correct – although clearly we are biased given our underweight stance on credit. It is also fair to expect that credit will be more adversely affected by the tightening monetary policy that equity. However, at the very least it is worth noting that standing just six weeks prior to expected Fed liftoff HG credit spreads are 9.5bps per percentage point of equity vol, or twice the 4.7bps/% we saw six weeks prior to the 2004-06 rate hiking cycle." - source Bank of America Merrill Lynch

Are equities priced for perfection or is credit already reflecting the tightening stance of the Fed? The jury is out there...

"A sword never kills anybody; it is a tool in the killer's hand." - Lucius Annaeus Seneca

Stay tuned!