Macro and Credit - The Ninth Wave

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself." - Stefan Zweig (1881-1942)

While chuckling about the gullibility of some investors pundits who were somewhat surprised by the Bank of Japan' latest move in implementing Negative Interest Rate Policy (NIRP), given as per the SNB move in 2015, they should know by now that central bankers always lie, we reminded ourselves The Third Wave experiment when thinking about our title analogy. While you might be already wondering why our title is the Ninth Wave and not the Third Wave experiment, it is fairly easy to explain. 

The Third Wave experiment was conducted by school history teacher Ron Jones during the first week of April 1967 in Palo Alto in California in order to explain his students how the German population came to accept the actions of the Nazi regime during World War II. Jones started a movement called "The Third Wave" and told his students that the movement aimed to eliminate democracy (in our central banks case: "interest paid"). Jones experiment (in similar fashion to current central banks experiments with QEs and NIRP) on the fourth day of the experiment quickly decided to terminate the movement because it was slipping out of his control. The experiment was all about explaining the rise of fascism. In our current environment, our central bankers "deities" are indeed experimenting with some form of "fascism" with their intent in imposing "financial repression" and discipline to the markets, we think.

So why our title?
Jones based the name of his movement, "The Third Wave", on the supposed fact that the third in a series of waves is the strongest, an erroneous version of an actual sailing tradition that every ninth wave is the largest hence our chosen title.

But, back in November 2011 we discussed a particular type of rogue wave called the 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 crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?

If 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 is a possibility we fathom." - Macronomics - June 2013

At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:

"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."

What is of interest of course is that indeed the Third Wave experiment analogy has been somewhat validated by Goldman Sachs in a recent research report as per below chart:

- source Goldman Sachs.

This ties up nicely with our "reverse osmosis" theory we mentioned again in our previous conversation "Under pressure"(This global macro hypothesis was first described in our August 2013 conversation "Osmotic pressure").

But if the sailing tradition that every ninth wave is the largest is true, then again, our chosen title is the correct one.
The Ninth Wave happens to be as well a splendid painting from 1850 by Russian Armenian marine painter Ivan Aivazovsky. Overall, our title refers to the nautical tradition that waves grow larger and larger in a series up to the largest wave, the ninth wave, at which point the series starts again. This of course goes with our earlier quote from Stefan Zweig. Zweig's quote does ring eerily familiar with the reckless abandon in which central bankers of the world are engineering the biggest bond bubble (or wave) ever seen, and the Ninth Wave might eventually turn out to be Wave 3 squared result but we ramble again...

In this week's conversation we will once again reiterate our advice to start playing "defense" in credit and move higher into the capital structure and in the ratings spectrum. We will also look at the debilitating global growth outlook as well.

Synopsis:

• Credit - Time to play defense on any "relief" rally
• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe
• Macro -  Growth outlook? It's weaker than you think
• Final chart - Why a flatter yield curve is not good for the financial sector

• Credit - Time to play defense on any "relief" rally

As we pointed out recently, half the High Yield universe by market value today trades at 310bps, while the other half is at 1050bps. While the distressed list has a disproportionate representation of commodities (33%), this dispersion doesn't bode well for US High Yield, given default and distress ratios are increasing, even outside commodities. 

We commented recently that the higher the "distressed glut", the lower will be the recovery rate. Also, the number of distressed bonds is rising in Europe and of course our favorite "CCC credit canary" issuance levels has plummeted. When it comes to issuance levels and US High yield, year-to-date issuance is down by -16.3% according to SIFMA.

While looking more into issuance levels, we looked at the data provided by Dealogic through the blog Credit Market Daily from Dr Suki Mann, former UBS European Credit Market Strategist. When one looks at High Yield corporate bond issuance, one can clearly see that the issuance levels, given market gyrations have fallen from the proverbial cliff in January:

- graph source creditmarketdaily.com 

As we repeatedly pointed out in our missives, like any behavioral psychologist, we tend to focus on the process rather than on the content. Whereas every pundits and their dog focus these days on the correlation of oil and the relationship with equities, and fathom on a potential rebound of both, we prefer to stick to what we are seeing which is the evident deterioration in the broader credit picture and the implication for equities. The "process" is playing out we think. While yes we can expect indeed a short-term "Keynesian" rebound, we do remain medium to long term "Austrian" bearish and cautious in the grand scheme of things.

For instance, we reacquainted ourselves with what is happening in the Securitization world as of late, reading through Bank of America Merrill Lynch latest Securitization Weekly. We particularly read with attention their latest note from the 29th of January:

"Overview – Things are bad, at risk of getting worse

The bounce in oil should provide some near term upside/relief in securitized products (SP) credit, but will it last? Financial stress receded this week, but it is unprecedented for the Fed to be tightening at current elevated levels. As cheap as SP credit has gotten, we think additional downside risks are too high; stay long duration in agency MBS.

Last week, we compared the price pattern of ABX, the subprime index, back in 2007- 2009 with oil in 2014-2016 (Chart 1).

Our interest in oil stems from the correlation between securitized products credit prices and oil over the past year , as well as the correlation between oil and inflation breakevens, which underlies our recommendation to buy long duration agency MBS.

The ABX-oil comparison last week suggested to us that oil had the potential to decline down to the low 20s by March-April of this year. Naturally, oil rallied this week on that analysis, as news of some potential tightening of supply hit the market. Our experience with ABX tells us that these types of rallies are not unusual within the context of precipitous price declines and that fading the oil rally most likely makes sense. Given the correlations cited above, this suggests that selling or at least fully hedging riskier securitized products credit also makes. If oil goes lower, prices on mezzanine risk transfer, CMBS and CLOs are also likely to go lower, even though they are already at the cheapest levels in recent history.
To make matters worse, and to heighten the potential for some chaotic price declines, there is the matter of Fed policy. As we discuss next, given elevated levels of financial stress, we think the Fed’s decision to start tightening monetary policy in December created significant risks for financial markets. This week’s decision provided little indication to us that this risk will meaningfully alter policy decisions going forward. This suggests to us that downside risks for securitized products credit remain elevated, even after significant price declines in recent weeks and months.
This week’s rally in oil prices may be a precursor of some near term strength for mezzanine risk transfer, CLOs and CMBS, subject to the constraints mentioned above. We recommend either reducing or hedging exposures into such strength and moving up in quality to high quality, short spread duration sectors such as auto ABS. Meanwhile, we continue to recommend long duration agency MBS, with an added emphasis on prepayment protected stories with the 10yr yield dropping below 2.0%

Global financial stress on the rise

In Chart 5, we focus on the rise in financial stress since mid-2014, and show the 50-,
100- and 200-day moving averages.

The stress periods are seen as somewhat episodic, with stress rapidly elevating, and then subsiding, moving more or less back to the trend line defined by the 200-day moving average, which itself is steadily trending higher. The daily peak for the last two years was seen recently on January 20, and stress appears to now be subsiding, probably moving back to the 200-day moving average over the near term. Declining financial stress should be good for financial assets over the near term, including securitized products mezzanine credit. It probably will also give the Fed more comfort in hiking rates in March. This is where we see potential for additional downside in securitized products.

Consider the 2007-2009 experience for financial stress. Chart 6 shows a similar view to the ABX-oil view in Chart 1, benchmarking 2014-2016 versus 2007-2009.

The current cycle, where the January 20 peak was 0.65, appears benign relative to the super stressed levels of late 2008, when the GFSI hit a peak level of 3.01, almost 5x the current level. But just a week before the September 15, 2008 (the start of the global financial crisis), and for the prior year for that matter, the GFSI registered levels near 0.60, or right at about current levels. We have little reason to anticipate a shock to the financial system on the order of the financial disruptions during the GFC. But we think it is important to recognize that the pre-GFC financial stress is comparable to today’s levels, suggesting system vulnerability to shocks or policy errors.

It is in this context that we view the Fed’s tightening of monetary policy as very risky for financial assets. As Chart 7 shows, in 2007, with comparable levels of financial stress, the Fed was aggressively easing, not tightening; now, the Fed is tightening.

Tightening may be the correct policy for the Fed’s economic mandate, but that doesn’t mean financial assets will approve. Moreover, what makes matters more disconcerting for us this time is that, given the change in the political climate relative to the financial sector since 2008, it seems unlikely that there would be a strong (if any) policy response to financial system stress. The days of the Fed put, which arguably has been in effect since October 1987, appear to be over."

To get some sense of what might accompany higher levels of financial stress, we look at the relationship between oil and the GFSI over the past two years in Chart 8.

We actually show the inverse of oil, so oil in the 20-25 range corresponds to an inverse in the 0.4-0.5 range. Very roughly, Chart 8 suggests that if oil drops down to the 20-25 range, the GFSI could head up the 1.0 vicinity. This was the stress level last seen in 2011, which was “solved” by QE3. Would QE4 come in response to a return to comparable levels of financial stress? It’s possible, but given the recent track record, the Fed seems more likely to keep moving in the opposite direction of tightening. This scenario is not likely to be a good one for securitized products credit, in our view."- source Bank of America Merrill Lynch

While we agree with most of the points made by Bank of America Merrill Lynch made in their note, while we reading their interesting note a graph caught our attention, reminiscent of the heyday of 2007, namely the price action in both ABX prices and CMBX prices:

 - source Bank of America Merrill Lynch

Given all of the above, we strongly advocate selling "high beta" into strength and moving towards a more defensive position such as long duration and US high quality Investment Grade "domestically" exposed credit and/or very long dated US treasuries (30 years) or playing it via ETF ZROZ (for retail players).

If you want more compelling "arguments" validating our defensive stance we strongly recommend you read the latest note from Bahl & Gaynor - "It's not what you own that kills you… it's what you owe"

So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.

As per Bank of America Merrill Lynch Credit Market Strategist note from the 29th of January entitled "The great rotation into US credit", we agree with the points they are making:

"After the ECB meeting last week, and US data and BoJ this week, we think that the widening yield differential between US and foreign fixed income will re-ignite foreign demand, as US corporate bonds look increasingly relatively attractive (Figure 6).

Apart from the effects of US data strength, a lot of this relative re-pricing happened because actual and expected foreign monetary policy easing tends to widen yield differentials with US Treasuries (Figure 7).

Obviously it may take a little time before yield sensitive foreign investors transition from the initial stage of finding the new lower absolute yields unattractive, to appreciating that US corporate credit now looks much more attractive on a relative yield basis, and increase their buying (Figure 8).

Corporate yield differential between USD and EUR

While at the time of writing our index system had not updated for Friday’s market movements post the BoJ, as of yesterday (1/28) US and EUR 10-year corporate bonds yielded 4.10% and 1.94%, respectively, for a yield differential of 2.16% - up from 1.98% last week:

Post-BoJ Japanese corporate bond yields and spreads

Due to a favorable time zone our Japanese corporate bond index has in fact updated for the post-BoJ Friday session. We see that in reaction to BoJ negative interest rates, yields declined 6bps to 0.25% while spreads widened 1bp to 29bps (Figure 11).

In our experience Japanese investors have been heavy buyers of US corporate bonds since 2012 – initially mostly on a currency hedged basis but increasingly unhedged. Clearly we expect more buying, especially after the April 1st start of the new fiscal year in Japan. However, today’s -7.5bps move in the cross currency basis swap initial negates the additional yield advantage to US credit created by the BoJ’s action." - source Bank of America Merrill Lynch

If you want to somewhat "front-run" the GPIF and Mrs Watanabe, increasing allocation to US domestically exposed high quality Investment Grade credit makes sense as per Bank of America Merrill Lynch's note:

"US strength, global weakness. 

Our preliminary analysis of the 4Q earnings reporting season for US HG companies shows little evidence that the US economy is going into recession. Specifically for global high grade companies that derive more than 50% of revenue from abroad we are tracking -5% earnings growth for 4Q, a small deterioration from the actual reported number of -2% in 3Q. However, for domestic companies without foreign revenue earnings growth is tracking +8% in 4Q, which is strong even if down a bit from +10% in 3Q. In terms of topline growth we are tracking -5% for the global companies and +8% for their domestic counterparts – both numbers virtually unchanged from 3Q." - source Bank of America Merrill Lynch

Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.

When it comes to following the flow and once again on why we focus on the process rather than the content, you have to "follow the flow" and when it comes to the implementation of NIRP, think clearly about the "implications".

• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe

Back in March 2015 in our conversation "Information cascade", we stressed the importance of following what the Japanese investors were doing in terms of flows:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

One should therefore not be surprised of the latest actions of the Bank of Japan in implementing NIRP which has already been implemented in various European countries and enforced as well by the ECB. As a reminder from last year conversation, this is the definition of "Information cascade":

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

The Bank of Japan has merely engaged in the same acts as others. "Information cascade" is a trait of behavioral economics. You get our point when we state that we behave like behavioral psychologist when analyzing market trends and central banks "behavior".

When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin as per Nomura JPY Flow Monitor report from the 15th of January 2016:

"We expect toshin momentum to remain strong in 2016, as suggested by the recent recovery. The maximum amount of risky asset investment under NISA per year has been raised since the beginning of the year. Risky asset investment via NISA tends to be especially strong in January, which will support toshin momentum in the near future. Risk sentiment among retail investors remains the key driver of toshin momentum too, and the latest Nomura Individual Investor Survey suggests a further recovery in retail investors’ appetite for risk assets. The survey also shows a strong preference for USD among foreign currencies, suggesting retail investors are likely to be dip buyers of USD assets via toshins.

The share of US assets in total foreign currency-denominated toshins continued to rise to 58.9% in December from 58.8% the previous month, the highest share since December 2001. US assets held via toshins declined to JPY17.1trn ($143bn), but non-US asset exposure declined more rapidly, especially exposure to EM assets. Interestingly, the share of EUR assets increased to 8.2% from 7.9% the previous month, while outstandings held in EUR-denominated assets inched up to JPY2.4trn ($20bn) from JPY2.3trn. November BoP data showed a recovery in Japanese investment in EUR-denominated securities, and the stabilisation in toshin companies’ exposure to EUR assets is worth monitoring, as it may show a gradual recovery in Japanese investors’ preference for EUR." - source Nomura.

Of course the woes of the Brazilian Real have been exacerbated by Mrs Watanabe and her growing dislike for her preferred carry trade since 2009...

Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP.

Whereas this is our assessment, when it comes to "front-running" the risk appetite of the Japanese crowd, although the "Ninth Wave" painting has warm tones in similar fashion than the upcoming "Japanese" allocation, which reduce the sea's apparent menacing overtones and tone of the market, the "macro" picture overall remains menacing as per our next bullet point.

• Macro -  Growth outlook? It's weaker than you think

We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should the reverse decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy. Particularly given the messages sent by various markets as illustrated recently in Bank of America Merrill Lynch's GEMs Inquirer note from the 28th of January entitled "The Dark Messages of the Markets":

"Mkts consistent with a double digit contraction in EMs EPS

We respect the messages embedded in diverse markets. We highlighted the signals from Dr. Sotheby’s (BID), Dr. Haliburton (HAL), and Dr. Copper, all falling more than 50% from their recent highs – which could reflect weak demand from plutonomists (rich people), energy capex, and Chinese infrastructure – the key drivers of global growth in the past fifteen years.

Additionally, other indicators including transport stocks, the Baltic Dry Index, high yield bond spreads, the KOSPI, cubicle makers, shipping companies, palladium prices, the stock-bond ratio, are all suggesting a severe earnings recession in Asia and emerging markets. How severe? For EMs, USD EPS growth could contract about 15% in 2016. Consensus is at plus 8.4% EPS growth for 2016 for emerging markets (and 6.5% for Asia ex-Japan). (We combine all these growth-sensitive market prices into one indicator to divine EPS growth). Its message is consistent with Nigel Tupper’s global earnings revisions index. From these levels, both have been associated with policy easing, not tightening. We remain suspicious of cheerful consensus growth forecasts, which display a persistent upward bias, and are likely to be revised down. The Wu-Xia synthetic Federal funds rate (Bloomberg: WUXIFFRT Index) LEADS EM equities by 18 mths, and has been tightening since mid-2014, and the Fed forecasts further tightening by 100bps this year.

Valuations not close to cheap in Asia/EMs

Asia ex-Japan is trading at an EV/Net income of 19.9x, compared with an average of 21.7x over past 21 years. This is 0.2 standard deviations below the mean. At market lows, it normally gets to levels around 13x. We would caution against getting too excited by the 1.2x PB in ex-Japan Asia (and EMs) – the ROEs in both region are under pressure, and flattered by a rise in corporate leverage. We need to see a stand-still (or a reversal) of US monetary tightening for us to re-assess our negative views. And/or, much better value." - source Bank of America Merrill Lynch

The question therefore you need to ask yourself is if the FED is going to eventually "blink" during the course of 2016. Because, as put bluntly in Bank of America Merrill Lynch's note, all the Doctors put together do not point towards a "bullish" outcome for growth:

- source Bank of America Merrill Lynch

Financial conditions since mid 2014, that's what credit is telling you, that's what oil prices are telling you and that's what the 3 doctors have been telling you. The damage has been done and while we can understand why the FED has decided to defend its "credibility", we all know looking at the lofty valuations touched, that they should have tightened much earlier one rather than boosting further up "asset prices" for the "plutonomists" to paraphrase Bank of America Merrill Lynch.

In our conversation of November 2013 entitled "Squaring the Circle", we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. It has proved a timely indicator of potential global stock markets reversal. Whenever its price reached 50 or so with sky high valuations, a reversal has never been far away. 

Finally, when it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the US financial sector which has been vaunted by some as a "compelling" buy. We will dispel this belief in our final chart.

• Final chart - Why a flatter yield curve is not good for the financial sector

We have been fairly vocal on our take on the direction that US long bonds would take given our deflationary incline. We have in fact hinted on numerous occasions that we had  been increasing our long duration exposure in conjunction with playing the rebound in gold miners (yes, disclosure we are as well, long ABX aka Barrick Gold). 

But if the 3 Doctors listed above don't tell you enough about the state of affairs, then, maybe the state of the US yield curve might tell you a little bit more. To that effect, we would like to point out the shape of the yield curve for our final chart extracted from Bank of America Merrill Lynch latest Securitization Weekly from the 29th of January:

"This week gave some indications of what this somewhat bleak view of ours might mean for rates and the yield curve (Chart 9): as of writing, the 10yr stands at 1.94, the lowest level since April 2015, and the 2yr-10yr spread of 115 bps is the lowest since early 2008. 

This is consistent with what we are looking for this year and why we have persistently recommended a long duration exposure in agency MBS, down in coupon (DIC) in passthroughs and Zs in CMOs. Following on the above discussion, we still see things as follows: the Fed likely will continue to push up short rates and thereby lower growth expectations, anchoring the back end of yields, and flatten the yield curve even more. The only change from this week is that, with new lows in treasury yields, we emphasize the need to own relatively stable long duration assets." - source Bank of America Merrill Lynch

Yes indeed, flatter is not good. And if, like us, you think that US Financials are the second derivative of an economy, meaning that putting on the "beta play" would only be justified by an acceleration of the growth outlook (loan growth) then, we think, there is nothing compelling in playing the "supposedly" value play in US Financials (When it comes to Europe, you already know our stance, stay out of it).

To complete our rebuttal of the "attractiveness" of US Financials, we would like to point out towards  Reorient Group strategist David Goldman's take in their note from the 21st of January entitled "Where to Hide?":

"Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy. As we observed in our Jan. 18 Week Ahead report, the deterioration of credit conditions and the flattening of the yield curve have left the banks with sharply reduced earning potential. The banks invest more in Treasury securities than in business loans, and the flattening yield curve crushes the differential between their cost of funds and the yield they earn on Treasuries.

Banks’ net interest margin is already at the lowest level in history.

- source Reorient Group

So, before you decide to jump again on the "beta" wagon, think very clearly on how US Financials can be "profitable" in such a deflationary environment and a significant flattening of the yield curve.
There might be at least some solace in US Financials versus European Financials (in particular Deutsche Bank and Italian banks woes), but apart from that, we don't see any "screaming buy" in the former and "zero interest" in the latter.

"Growth is the only evidence of life." - John Henry Newman, British clergyman

Stay tuned!

Macro and Credit - Under pressure

"A financial crisis is a great time for professional investors and a horrible time for average ones." - Robert Kiyosaki, American, author

Given the additional strains shown in recent days in various markets, and that last week we went for another musical analogy from the 80s, the troubling gyrations in the credit markets with the significant widening of some solid Investment Grade issuers, made us this time around choose for this week's title analogy Queen's famous 1981 "Under pressure" song featuring the recently departed great singer David Bowie. 

While we have been warning long in advance the debilitating state of the credit markets and in particular the High Yield market, what is of concern to us, as of late is that fragility is now showing up as well in some parts of Investment Grade credit markets. For sure the CDX IG 100 bps t-shirt has been picked from the closet where it had been collecting dust since the hayday of the Great Financial Crisis (GFC).

In this particularly long conversation we will again discuss the significant rise in idiosyncratic risk and the spillover into the Investment Grade markets and the potential consequences as well as some points of weaknesses in the Energy sector which are worth highlighting from a "bear" market perspective and explain the rational behind the boom and bust of the commodities' bubble.

Synopsis:

• Credit - More spillover from High Yield into Investment Grade
• Credit and Oil hedges - a paradox
• Credit and the Oil and Gas sector - it's scary out there
• Final chart - Credit on the brink of a blowout – watch global recession risk

• Credit - More spillover from High Yield into Investment Grade

As we pointed out on our Twitter feed recently, if you think there is no contagion/stress in credit then, looking at the significant large standard deviation move in terms of CDS 5 year widening of Rolls Royce, a solid single A, following its outlook cut by S&P from stable to negative is a harbinger of the deterioration in credit:

 - graph source Bloomberg

While, from a flow perspective we have yet to see significant outflows in that space from the easily scared "retail crowd", we are monitoring closely the situation and we think you should too. Whereas the weakness so far in Investment Grade in particular has been relatively muted, it could potentially get nasty fairly fast. In terms of flows monitoring, we have read with interest Bank of America Merrill Lynch's take in their Follow the Flow note from the 15th of January entitled "Counting Casualties":

"An outflow week for most asset classes 

The year has not started on a positive note. Fund flows continue to point to the downside in fixed income, and equity fund flow shows signs of weakness too. Equity funds were hit by outflows last week; the first in 15 weeks.Starting with credit, outflows were recorded across the rating spectrum. High grade flows turned negative again, after a brief week of inflows at the start of the year. High yield was on the same trajectory and outflows mounted to more than $1.5bn. This was the sixth week of outflows, and the highest one in three weeks. 

Elsewhere in the fixed income world, government bond funds had a second week of small inflows, amid broader risk aversion.Money market fund flow was also on the positive side and saw a third week of inflows, as investors looked for “safety”.Equity funds were not shielded from the sell-off storm. For the first time in 15 weeks, the asset class recorded an outflow, however marginal, which is also the largest in 20 weeks.Global EM debt fund flows also tipped back to negative, after recording two brief weeks of inflows." - source Bank of America Merrill Lynch

We have repeatedly pointed out the similarities of the late cycle to 2007, when it comes to the buyback binge inducing a rise in leverage, loose covenants and large issuance of Cov-lite loans, as well as record M&A, all indicative of a late stage in the credit cycle. From a comparative point of view we would like to point out to Bank of America Merrill Lynch's chart from their Monthly Chart Portfolio of Global Markets note of the 20th of January entitled " Welcome to 2016: Risk off grips world markets, so chart it":

"Sobering chart: High yield OAS breaks out like its late 2007/early 2008

The Barclays US Corporate High Yield Average OAS is widening out of a 3-year bottom. The last time this high yield spread widened out of a similar bottom was late 2007/early 2008 when the spread completed a 4-year bottom and continued to widen out. This was just prior to the depths of the 2008 financial crisis. We view this as a US equity market risk. A move back below the 5.50-5.30 area is needed to call this high yield OAS breakout into question." - source Bank of America Merrill Lynch.

We have warned you well in advance of the contagion risk in numerous conversations and told you that at some point credit spreads would continue to come "Under pressure", which could lead, we think to additional contagion from High Yield to Investment Grade.

Of course there have been plenty of reason at the start of the year with most risky assets coming simultaneously "Under pressure" as indicated by Société Générale in their Credit Strategy Weekly note from the 15th of January entitled "Not the best start for sure":

"2016 could have started better:  

The start to the year could have been better. Concerns over China, oil prices performing poorly, worries about EM and more idiosyncratic risk worries have hammered the markets and credit has not been immune. Spreads in IG are already some 15bp wider than at the turn of the year and the total return in IG is already down to -0.29%. But the results are even worse elsewhere. Equities in particular are down 8%, EM is starting to drop hard, commodities are depressed and since sovereigns don’t pay much we believe that this environment will help credit in general. Yes, the start to the year could have been better, and with the current volatility, spreads will continue to slide, but when you see InBev in the market with a $45bn 7-tranche transaction with orders of about 110bn, well it just shows that the appeal for credit remains very strong. 

What could go right? 

The cycle of China worries, weak oil, falling stock markets and rising credit spreads was very much in evidence this week. Credit had been a relative outperformer since the middle of December, and the big size of the InBev book gave hopes to some that it would stay that way. But US high yield markets are leading global credit markets at present, and fears of defaults in the US market (due to cheap oil, but also to weak growth) are driving up US high yield spreads.

Oil goes up 

The decline in oil has been driven by the supply side, but what if oil were to rally due to changes on the demand side? Investors do expect US shale supply to drop as companies default, though we ourselves think that this year’s US defaults are likely to be lower than the market expects, since companies probably have enough liquidity to limp through this year. A bigger supply shock could take place due to political risk in the Gulf. Recent tension between-Saudi Arabia and Iran has not had an impact on oil prices, but if it were to get worse, then oil prices could bounce off $30/brl. 

How to position for it 

The big winner from such a scenario would be US high yield markets, and particularly the energy sector. The big loser would be Saudi Arabia. Selling US high yield protection at 525bp and buying 5yr Saudi protection at 200bp would make sense under this scenario.

Monetary policy gets easier worldwide 

Our US economists expect rates to rise three times this year, with the next hike expected to come in March. Of course, if the turmoil in emerging markets begins to provoke concerns about deflation in the US, this could stay the Fed’s hand. A reversal in monetary policy in the US would impact USD credit, but it might have an even bigger impact on rates in Europe and elsewhere, since market participants might begin to wonder how other central banks would keep their currencies soft if US interest rates are no longer likely to rise. The zone with the biggest pressure on clients to meet their interest rate targets is still Europe, so European credit could be the biggest beneficiary. By contrast, concerns about the lower limit problem in Europe would come back in a big way, and the European credit curve relative to ratings would flatten.

How to position for it

If monetary policy eases – starting in the US, but spreading elsewhere – then the bonds that would benefit most would be longer-dated BBB credits in Europe. By contrast short-dated high quality credits (of single A or above) would do poorly.

Reallocations from EM cease 

One big driver for the recent EM weakness has been portfolio reallocations from EM to DM markets. These may be getting close to ending. Our bigger fear is that two other reallocation trends happen in EM this year. The first is that DM banks lend less to EM customers; the second is that EM companies issue fewer corporate bonds in dollars, and more in local currencies. Both trends would increase pressure on EM currencies in the short term and that could rebound on credit (although EM corporates in USD might be a beneficiary). If this trend develops more slowly than we, or the markets, expect, then we could see EM currencies improve and global credit markets also do better. 

How to position for it 

Ironically, we think developed credit markets seem more sensitive to emerging market currencies at the moment than emerging market credits. The big beneficiary of successful EM issuance in dollars ought to be EM bonds, however, and the best performers probably would be beleaguered Latam oil credits.

But is this likely to happen? 

Of the three scenarios above, the most likely at the moment seems to be the second one. However, since easier monetary policy might also spur growth hopes and drive oil prices higher, the first scenario could come about as a result of the second. We therefore think that investors looking for the upside in corporate bonds should invest in US high yield (which has sold off the most, and represents the best value), and in European IG (which would be most sensitive to another move lower in yields)." - source Société Générale

We do agree with the second point, namely additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdosis", we think.

When it comes to credit and what is getting us concerned is the deterioration of market internals as highlighted by DataGrapple's team in their latest blog post:

"Believe it or not, despite a 10bps widening of iTraxx Main (ITXEB24) - from 86bps to 96bps -, buy side institutions have (almost) not bought protection on that index last week. They only cut their long risk positions by the equivalent $0.4bln across the 8 most recent series. That probably goes a long way in explaining the stubbornly negative basis (the difference between the quoted value of the index and its theoretical value) of ITXEB, as investors rushed to buy single entity CDS on the energy sector. The reach for protection on oil related names was even fiercer in the US (the sector is whopping 85bps wider at 455bps in investment grade over the past 5 sessions). So fierce that even a reduction by a third of long risk positions in CDXIG – from $36.8bln to $22.9bln across the 8 most recent series – and a 12bps move wider – from 97bps to 109bps - did not prevent the basis to reach the most negative levels since the Great Financial Crisis. That trend only accelerated today, and the basis of CDXIG25 stood at almost 1% at the European close." - source DataGrapple

The stubbornly deeply negative basis between single names and indices clearly indicates there is potential for more widening for the credit indices going forward and warrants as well close monitoring we think.

The question that comes to our mind of course, given the last violent episode in credit spreads coming under pressure was 2011 is if indeed "this time it's different"? To a certain extent it is. The epicenter of the pressure in 2011 on credit spreads, was coming from the financial sector coming under relentless pressure which run its course when the ECB initiated its LTRO program back in December 2011. This time around, Itraxx Financials CDS 5 year index remain for the moment well below the Itraxx Main Europe Financial 5 year CDS index, indicating that the pressure this time around is building up more into specific buckets of the corporate part, namely the Energy sector. This is as well indicated in Bank of America Merrill Lynch's Relative Value Strategy note from the 20th of January entitled "The anatomy of a sell-off":

"This time has been differentOther than the crisis years, the only other time IG and HY have been at or above current levels is during the 2011-12 period (Chart 1 and Chart 2). 

But in our view it would be a mistake to characterize the indices in their current state as being akin to their 2011-12 avatars. We believe the difference is largely due to the systemic nature of the sell-off then and the prevalent view today that credit issues are largely idiosyncratic and isolated to a few names/sectors.

The source of portfolio dispersion in IG in particular has been the commodity sector. As Chart 4 shows, non-commodity IG continues to trade relatively tight. Even with the index at 110, IG index minus the commodity issuers CDS results in a portfolio at 69bp.

In HY, the distinction between the non-commodity and the admittedly smaller commodity exposure is not as stark

In a similar vein, the low beta portion of the IG portfolio has barely participated in the sell-off. In fact, until the end of last year, it even managed to ‘decouple’ from the widening in the index, deigning to join in only in the last two weeks:

As a proportion of overall portfolio spreads, the contribution of low-beta names is now the lowest in over three years as commodity-related issuers dominate the tail: 

The distinction between the spread moves in the tail relative to the rest of the HY portfolio isn’t as stark as in IG, but the spread contribution of the non-tail names is on the lower side compared to the last 5-6 years:

Single-name volatility within the HY portfolio has increased in recent months, with the proportion of names experiencing more than a 50bp widening each week, similar to that observed in 2012. The distressed ratio too has ticked up, from around 14% in October to 18% now." - source Bank of America Merrill Lynch

Conclusion:
While in High Yield there has been pretty much an overall deterioration with some contagion and spreads widening in sympathy with the Energy sector albeit at a slower pace, it remains to be seen how long Investment Grade is going to hold the line. So far, apart from the "sucker punches" à la Renault or Volkswagen and more recently with Rolls Royce, it appears to us that we are more into an early 2007 scenario for the time being (but things could escalate quickly still). As long as outflows remain muted in the Investment Grade bucket, Investment Grade remains resilient for now. Yet, the overall tone of the market suggest to us that financial conditions continue to tighten thanks to the battering of the Energy sector which will no doubt put lenders towards a more cautious stance, which will accentuate therefore the tightening conditions we are clearly seeing in the High Yield space (it started already with our "CCC credit canary" and recent LBOs tentative are struggling to place debt).

Moving on to the significant widening in High Yield Energy following the continuous fall in oil prices, we find it interesting the divergence in hedging policies between High Yield issuers and Investment Grade issuers. We will address this important paradox in our next bullet point.

• Credit and Oil hedges - a paradox

Whereas Brent crude oil prices have relentlessly falling in recent weeks following a disappointing OPEC meeting on December 4th, we had to wait until Thursday to finally see a significant rebound in oil prices as well as in risky assets, with a vicious short covering rally in which "Le Chiffre" aka Mario Draghi played a magnificent part, no surprise, him being a poker prodigy in comparison to the much more lame players at the FED.

As we correctly pointed out in our December conversation "Charles law", 2016 is already showing its capacity in inflicting serious volatility and damages in a very short time frame:

"2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016." - source Macronomics, December 2015

But, when it comes to assessing credit and oil hedges, it seems that High Yield issuers and Investment Grade issuers have had difference risk approach as indicated by Bank of America Merrill Lynch in their Global Energy Weekly note from the 8th of January entitled "Can oil prices find a floor?":

North American producers remain notoriously under-hedged in 2016… 

Despite a last minute rush to lock in hedging deals last November and December, we believe that North American crude oil producers remain notoriously under-hedged on their 2016 crude and nat gas price exposures:

Back in June 2015, we argued that North American companies (both high yield and high grade) were under-hedged for 2016 by 640 million barrels relative to 2014 levels (see The billion barrel question). We now estimate that less than 200 million barrels have been hedged since then. In other words, another 440 million barrels of oil would still need to be hedged in 2016 to match 2014 hedging levels:

…and unhedged for 2017 too, suggesting more selling pressure 

True, given the sudden collapse in longer-dated oil prices, many companies have little incentive to hedge at the present time as their production breakeven costs are typically higher than today’s forward crude oil prices. In broad terms, high yield energy companies (Chart 5) have higher hedge ratios than their investment grade peers (Chart 6).

Partly as a result of their higher sensitivity to funding cycles, levered high yield energy companies have tended to hedge a larger portion of their production regardless of price. However, the gap has widened meaningfully this year, as high grade companies have largely stopped hedging all together, presumably deciding to “tough it out”.

Most hedging activity has now moved to the options markets… 

Interestingly, those high grade companies that have indeed decided to hedge production in recent months have done so using collars, an option structure whereby the producer typically sells a call to finance the purchase of a put, rather than swaps:

A collar will typically provide a lower level of protection in a falling market, so the change in hedging structure may be related to producers holding a more constructive price outlook than the market. In the high yield space, the most common hedging structure is still a swap, but the use of options has increased (Chart 8), with credit-constrained counterparts likely recurring to the outright purchase of put options.

…and more US oil & gas companies are now filing for bankruptcy 

With leverage ratios exceeding on average 4.3x, compared to last cycle highs of 3.9x, oil is “no country for old men”: 

Many high yield companies are finally starting to get into trouble. Bond yields for CCC+ rated energy companies have spiked to 30%, while the average bond in a non-investment grade E&P company in the US is now yielding 16%. Given the challenges to refinance, it is perhaps no surprise that in the third and fourth quarter of 2015 at least 20 US oil and gas companies filed for bankruptcy, largely exceeding the levels reached in 2H2008 or 1H2009:

Put differently, financial distress is here and it is finally starting to bite." - source Bank of America Merrill Lynch

Collars provide limited upside and downside protection by putting ceilings and floors on prices. Typically favoring collars only works in periods of moderate volatility and may be preferable to swaps because there is less exposure to loss if prices continue falling. The paradox is that Investment Grade companies have been using a lower level of protection offered by Swaps and have as well been far less agressive than their High Yield peers in "protecting" their production level.

What is as well of a concern is the relative high debt level versus EBITDA, basically the overall level of leverage in the US Oil and Gas sector as per our next bullet point.

• Credit and the Oil and Gas sector - it's scary out there

Whereas by now many have awakens to the serious implications in the velocity of the fall of oil prices relative to the Oil sector, what is scary out there, regardless of the most recent rapid rebound in prices is the significant of leverage of the sector as a whole as depicted by Deutsche Bank in their recent note from the 18th of January entitled "Credit Stress intensifies":

- source Deutsche Bank

No surprise therefore to read earlier today that ratings agency Moody's had put 175 Energy and Mining companies and groups on review for a potential downgrade downgrade.

Of course, the one and only culprit for the fall of oil prices we think has been the impressive rise of the US dollar since 2014 as shown by Deutsche Bank in their report:

- source Deutsche Bank.

The trajectory of the US dollar in the coming month and the velocity of the movement will be essential in determining the level of further stress down the line.

Furthermore, as shown by Morgan Stanley in their Leveraged Finance Insights note from the 14th of January entitled "Making Heads of the Tail", credit being "Under pressure", it is essential to quantify the "stress" and of course the "default potential":

"Quantifying the Stress:  

First looking at valuations, a lower proportion of HY debt is currently trading sub $70 versus 2000 and 2008, at 17%. However, because of the size of the market, the par value trading at distressed levels today is $176bn, already greater than $120bn in 2000 but less than $313bn in 2008. By sector, 50% of distressed HY debt is Energy today, compared to 47% that was Consumer Cyclical in 2008, and 36% from TMT in 2000. 

Quantifying Default Potential:  

We finish by translating the distribution of the tail in the market into long-term default potential. Based on this analysis we get to a 5Y cumulative default rate going forward of 24% if we assume the cycle is turning –which is more modest than the 2008 and especially the 1999 5Y default cohorts. While we could argue for a lower 5Y cumulative default rate going forward (assuming the cycle is turning) when comparing the current tail in the market to 2000 and 2007, the volume of defaults will likely be much larger in almost any scenario given the substantially larger size of the market today. In Exhibit 11 we show a rough approximation of US high yield and loan defaults over the course of a default wave, which we put together in our 2016 outlook. For the purpose of this analysis only (i.e., not our actual forecast), we assume the default cycle starts this year, peaks in 2017 (9.3% HY default rate in that year), with elevated defaults for four years. We assume a cumulative default rate of 25%, comparable with 2008, but more mild than the 1999 cohort. 

From this analysis, we get to $627bn in US high yield and loan defaults over five years. Note this number is significantly larger than the volume of defaults in the last two cycles because US leveraged finance markets are so large. If this default wave were to be as severe as the late 1990s or worse, default volumes would clearly be larger." - source Morgan Stanley.

Of course because of the Fed's overmedication, the problem have grown "larger" for "longer, which could indeed spell for significant amount of losses over the next 5 years as calculated above by Morgan Stanley. When it comes to the stage of the cycle, we are not yet on "Nightmare in credit street" as we think, the latest moves are reminiscent of 2007, but are nonetheless trending towards 2008 when it comes to assessing the default risks induced by the collapse of the commodity sector thanks to the rise of the mighty US dollar.

What triggered the boom and now the bust you might rightly ask? For us, it is pretty straightforward and ties up to our "reverse osmosis" global macro hypothesis described in our August 2013 conversation "Osmotic pressure":

"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." - source Macronomics, August 2013

Of course there is more to it, and it is linked to the relationship between global interest rate gap and commodity prices. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011 as a reminder:

"Negative interest rate gap 

In order to assess the relationship between changes in monetary conditions and developments in commodity markets, a good proxy is the “global interest rate gap”, which is the weighted average of
the interest rate gap in each country with its corresponding GDP used as a weight. The interest rate gap itself denotes the difference between the real interest rate, defined as the nominal short-term interest rate minus headline CPI inflation, and the potential growth rate of an economy. If the interest rate gap is positive, meaning that the real interest rate is higher than the potential growth rate, then the financial condition is tight. Conversely, if the interest rate gap is negative, it means that the financial condition is lax, as the real interest rate is lower than the potential growth rate.
As shown in Chart 7, the global interest rate gap has become more negative, albeit fluctuating, which suggests that global monetary conditions have become accommodative over the observation period.

The interest rate gap in developed countries turned negative through the mid 2000s during the so-called “Great Moderation” period, and has remained in negative territory, reflecting accommodative monetary policies since the Lehman crisis. Also, the interest rate gap in emerging countries has become more negative throughout the observation period. Admittedly, by a nominal measure, monetary policies in emerging economies have been tightened with rate hikes since late 2009, preceded by a series of rate cuts after the Lehman crisis as was seen in developed countries. However, rates in emerging economies have not been hiked sufficiently fast, given the strong inflationary pressure and increase in real output growth. This “behind the curve” situation has caused the negative interest rate gap to widen in emerging economies.

Relationship between global interest rate gap and commodity prices 

Global commodity prices are negatively correlated with the global interest rate gap, as seen in Chart 8. 

This is because rising commodity prices increase inflation, decreasing the real interest rate as a result. If the rise in commodity prices is driven by the narrowing of the global output gap and the intensity of the price surge is too strong, however, the real interest rate needs to be raised by central banks in order to tame inflationary pressure. Such a principle of central banks would lead to a positive correlation between global commodity prices and interest rate gap, and the increase in real interest rate then would cool physical demand for commodities and dampen the rise in commodity prices. But what Chart 8 shows is that monetary policy stance of central banks have not satisfied that principle on a global basis, and hence easier monetary conditions have boosted commodity prices.

For individual central banks, the fluctuation in global commodity prices may be an exogenous supply shock. Even if a single central bank attempts to counter the fluctuation in commodity markets, it may achieve nothing other than making the domestic economy more unstable. In other words, for each central bank, an independent action to tame global commodity markets may not be an optimal choice. This reluctance of each central bank to counter rising commodity prices, however, could cause them all to be collectively worse off, because it is likely to accelerate the surge in commodity prices and thus to expand the negative global interest rate gap. The failure of this collective action leads to a higher-than-expected increase in demand for commodities. This vicious cycle may develop self-fulfilling expectations of a further appreciation in commodity prices, thereby driving commodity prices above the equilibrium level justified by supply-demand conditions (as proxied by global output gap). The experiences in several countries also suggest that accommodative monetary conditions, as characterized by the negative interest rate gap, enhance the risk-appetite of investors and induce “yield-seeking” investment flows into financial asset markets. Eventually, this process may increase the probability of an economy becoming trapped in a bubble." - source Bank of Japan, 2011 paper.

Quod erat demonstrandum. When it comes to the boom and bust of the commodity bubble and our "reverse osmosis" theory playing out. This also ties up quite well with "the return of the Gibson paradox" we discussed in October 2013:

"What of course has been of interest is the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. 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." - source Macronomics.

QE2 (November 2010 to June 2011 = peak gold prices) and negative real interest rates from the US triggered massive flows towards Emerging Markets and commodities. The start of the tapering stance of the Fed and the road to normalization and "positive" real interest rates" in the US triggered the "reverse osmosis": Massive capital outflows from Emerging Markets, a massive surge in the US dollar and a collapse in commodity prices.

Overall the Fed is entirely responsible for the commodity boom and bust bubble. The negative interest rate gap of its QE, also put the risk-appetite of investors into overdrive and induced massive “yield-seeking” investment flows into financial asset markets. That simple...

Now the conditions are ripe for an epic credit blow out in Emerging Markets, in particular those who borrowed generously in US dollars as per our final chart and bullet point.

• Final chart - Credit on the brink of a blowout – watch global recession risk

If indeed our "reverse osmosis" theory is playing out, then indeed a further rise in the US dollar will be the catalyst for some countries experiencing major issues.

As the Osmosis definition goes:

"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell."

Given many Emerging Markets have been struggling in stemming capital outflows as of late, we believe some will experience "excessive osmosis" and the country will eventually "burst" (default). Our final chart comes from Bank of America Merrill Lynch's Emerging Convictions note from the 21st of January entitled "Black gold down"

"Credit on the brink 

The benchmark EMBI sovereign spread has risen to the top of the 15-year range and is now likely to either retrace or target the blowout levels of the 2001/02 or 2008/09 crises (Chart 7):

In most cases, spikes in the current level did not last long, as they resulted in a global policy response or value buyers emerging. So the crucial question here seems to be the likelihood of a full-fledged crisis scenario.

The key to this question is likely whether the negative side effects of the commodity shock will be severe enough to raise global recession risks. The Chart above shows the EM credit crises of the past 15 years were associated with US manufacturing ISM below 45, the level that is almost always associated with a GDP recession.

Our house economic and oil view implies that the world economy – and thus EM credit – will pull back from the brink. Our DM economists emphasize that the economy outside manufacturing remains robust. Our oil team has argued for a temporary dip to the mid-20s on China, Iran and the warm winter, but continues to expect a recovery above $40 by 2Q as demand grows and US supply contracts. Again, the crucial risk to this oil view would seem to be whether the oil supply shock mutates into a global demand shock.
If this view is correct, commodity credits look oversold. Nigeria stands out because it is already wider than during the Euro crises and post Lehman. Russia is wider than during the Euro crisis but below the Lehman levels, though it now has a flexible rouble. South Africa is close to its post-Lehman level. Among the commodity importers, Turkey is trading at the same z-spread as during the previous global financial stress periods. CEE remains tight vs historical blowouts due to improved fundamentals." - source Bank of America Merrill Lynch

Place your bets accordingly...

"But all bubbles have a way of bursting or being deflated in the end." - Barry Gibb, English musician.

Stay tuned!