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!

Macro and Credit - The fourth wall

"It is only with the heart that one can see rightly; what is essential is invisible to the eye." - Antoine de Saint-Exupery, French pilot and writer

While enjoying the festive season in Paris, we watched with interest a couple of interesting credit and market events that made us think about a theatrical reference which we decided to use as our title analogy. The fourth wall is the imaginary "wall" at the front of the stage in a traditional three-walled box set in a proscenium theatre, through which the audience sees the action in the world of the play (or markets). Speaking directly to, otherwise acknowledging or doing something to the audience through this imaginary wall – or, in film and television, through a camera – is known as "breaking the fourth wall" (think Ferris Bueller's day off...). The fourth wall being an established convention and given our disregard for conventions (us being contrarian), we will, therefore, in this first of the year conversation "break the fourth wall". The acceptance of the transparency of the fourth wall is part of the suspension of disbelief (or delusion) between the "fictional" recovery we have commented on numerous occasions and you, the audience.

Before we dive more into our first conversation of the year, which will relate once more to the state of affairs in the credit and macro space, we would like to make a quick parenthesis on two subjects of interest of ours, namely idiosyncratic risks in credit markets and the state of shipping (given for us it is not only a deflationary indicator, but a credit indicator as per our past conversations).

A good illustration of the idiosyncratic risk in the credit space was once more illustrated on the 29th of December by the price action relating to the "sucker punch" delivered to the senior bond holders of Novo Banco, the supposedly "good part" of former Portuguese bank Banco Espirito Santo - graph source Bloomberg:

- graph source Bloomberg

So what happened on the 29th of December that spooked the "innocent" senior financial bond holders you might rightly ask dear audience? Well, Bank of America Merrill Lynch in their note on Novo Banco from the 4th of January tells it all:

"The Bank of Portugal announced that, as part of the resolution of BES, it was transferring five bonds from Novo, back to the ‘bad bank’, BES. We believe that the resolution of BES could be viewed as a process and not a discrete series of events, since Novo is still a ‘bridge’ institution (the intention is that the resolution of Novo is complete when it is sold, although the deadline for the sale now appears to be indefinite). In our view, recovery on these securities should be viewed as uncertain as BES’s total assets were only €197m at end-2014 compared to a negative net asset position of €2.7bn, before the transfer of a further €2bn of senior bonds. It is our understanding that the senior bonds’ Governing Law is Portuguese. We note that in the original resolution of BES, the Bank of Portugal, as resolution authority, has reserved the right to move assets and liabilities between ‘bad’ bank and ‘bridge’ bank. In addition, the BoP appears to have chosen large denomination seniors, to avoid imposing losses on retail bondholders. In any case, with the transferred securities trading at ~€11, and BES now to be liquidated. 

Further losses could lie ahead 

Novo has in effect been given a further €2bn in capital post-transfer which, according to the company, means that its CET1 ratio has now increased to 13%. However, Negocios, at the end of 2015, reported that a further €2bn of ‘irregular’ loans linked to the ancien regime of the bank had been discovered (the newspaper adduces these irregular loans as the reason for the senior bail-in). The newspaper reports that the provisions relating to these exposures may be taken in 4Q15 (and beyond) leading to a significant deterioration in the accounts of the bank. Note Novo Bank did not comment on the press reports. The June report already detailed a loss of €252m. We would expect this to deepen through year end as provisioning likely catches up with the asset quality decline we saw at the bank in 2015. 

Cheap but we await clarity 

In our view the 5% bonds are quite cheap, with yields of nearly 10%. However, many erstwhile bondholders of Novo are now nursing substantial losses from their senior exposures – we assume this could lead to a degree of reluctance to take exposure on the name, at least for a while, which could mean poor technicals for the bonds. We understand that Novo is now better capitalised. However, this capital could come under pressure in the coming quarters if more losses are recognised. Events of the past few weeks have highlighted Novo’s problems and the fact that the deadline for its sale is no longer subject to public disclosure suggests a drawn-out sales process, especially as Santander has just bought Banif, so arguably does not necessarily need to add to its Portuguese assets." - source Bank of America Merrill Lynch

No, these bonds are not "cheap" and should be avoided. 

In addition to senior bond holders nurturing their losses, as of the 1st of January, depositors are now "pari passu" with senior creditors and are indeed next in the line of fire should additional "hidden losses" materialize (they will). When it comes to recovery assumption, we read with interest CMA (now part of Capital IQ)'s take on the estimated recovery value. They estimate it to be at 1%. You read that correctly. So much for an assumed recovery value of 40% for senior CDS. 

We might be sounding yet again in 2016 as a broken record but, we told you before dear readers, in the next downturn in credit, recovery values, rest assured, will be much lower. That's a given.

Moving on to the second part of our parenthesis namely "shipping", and "cheap credit", we read with interest the FT's recent article on the subject from the 3rd of January entitled "Cash burning up for shipowners as finance runs dry":

"The challenges facing DryShips are among the most acute of those facing nearly all dry bulk shipping companies after a slump in earnings drove most owners’ revenues well below their operating costs. Owners are haemorrhaging cash. Owners of Capesize ships — the largest kind — currently bring in around $3,000 a day less than the $8,000 they cost to operate. The losses for the many owners who have to service debts secured against vessels are far higher.
Basil Karatzas, a New York-based corporate finance adviser, points out that in an industry that has already been making steady losses for 18 months, such substantial losses quickly mount up.
“If you have 10 ships and you’re losing $3,000 to $4,000 per day per ship, that’s, let’s say, $40,000 per day, times 30 in a month, times 12 in a year,” he says. “You are losing some very serious money.”
The question is how long dry bulk owners — and the private equity firms which have invested heavily in the companies — can survive the miserable market conditions.
Michael Bodouroglou, chief executive of Paragon Shipping, another New York-listed dry bulk shipowner, says that owners are looking to negotiate partial repayments, standstills and payment moratoriums with their banks.
“They’re trying to batten down the hatches, reduce costs as much as they can,” he says.
Yet the brief arrest — seizure over unpaid debts — in November in Singapore of the Sparta, a Capesize dry bulk carrier controlled by private equity firms, illustrates why shipowners are especially pessimistic about this slump. The vessel’s arrest, at the request of Deutsche Bank, has been widely interpreted as a sign that banks’ readiness to keep amending loan terms to allow owners to ride out the slump might be coming to an end." - source Financial Times

We chuckled because although some pundits have the memory span of a goldfish, we don't and we clearly remembered the warnings we gave back in December 2013 on the billions poured by Private Equity players in the shipping industry in our conversation "All that glitters ain't gold":

"There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.
The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business

Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover.

The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry. " - Macronomics, December 2013

Given the "evident signs" of the recovery as displayed in the latest dismal print for the Baltic Dry Index to 467, a new record low (since its creation in 1985), one might wonder if indeed the PE players will make their "quick buck" on their "shipping" ventures. We don't think so:

- source Bloomberg.

Why we don't think so? Because "cheap credit" has led to "malinvestments" with PE pundits placing bets on a business they hardly know, and they have added overcapacity to overcapacity. Simply put, there is a "shipping" glut.

One can ascertained QEs and ZIRP have been deflationary by looking at the fall in the US of M2 "velocity":

-source CLSA

In similar fashion in the shipping industry, the "velocity" of ships aka their speed has been as well falling as reported by Bloomberg in their article entitled "Slowing Boat From China Provides Clue to Health of World Trade" from the 17th of December:

"Even with fuel at its cheapest price in almost a decade, the ships that carry goods around the world have been reducing speed in line with the slowdown in China, the biggest exporter.
Shipping companies have been “slow steaming” since the global financial crisis in 2008, as a way to save costs and keep as many ships active as possible. Vessels are now operating at an average of 9.69 knots, compared with 13.06 knots seven years ago, according to data compiled by Bloomberg. 

That means Nike sneakers and Barbie dolls made in China can now take two weeks to arrive in Los Angeles and a month to reach Le Havre, France -- a week longer than if the ships were moving at full speed. And there’s scope for ships to go even slower, according to A.P. Moeller-Maersk A/S.
“This is the new norm,” said Rahul Kapoor, a Singapore-based director at Drewry Maritime Services Pvt. “The overall speed of the industry has gone down and there’s no going back.”
In the boom years before the 2008 financial crisis, shipping lines expanded fleets and ran ships as fast as they could to keep up with the surging demand for goods manufactured half a world away. As demand dropped, the lines were left with too many vessels, and customers eager to reduce inventory, who would rather pay a lower rate to receive goods than guarantee quick delivery." - source Bloomberg

The new norm has been slower M2 velocity, slower growth, slower shipping. For the PE punters who have played the "recovery" game, they will have to face the "music". End of our parenthesis.

In this week's conversation, given the on-going "bloodbath" in the oil space, we will look at some of the implications. We will also look at the debilitating state of the credit markets once more.

Synopsis:

• US Energy sector (ETF XLE) versus oil price - Much more downside to come
• Credit - The credit cycle has turned and global financial conditions are tightening
• Final chart - Correlations getting higher in a macro-driven market

• US Energy sector (ETF XLE) versus oil price - Much more downside to come

While watching the continuous downward spiral of oil prices, what really struck us is the resilience from the US energy sector in the equity space versus the price of oil. We are convinced that there is more downside to come on the equity side - graph source Bloomberg from the 6th of January:

- graph source Bloomberg.

Whereas at the end of 2008, oil and XLE where trading roughly at the same levels, today it appears to us that ETF XLE as a proxy for the oil equity sector is still at least 30% above the lows of 2009 with an oil barrel at a much lower level. More pain to come, we think...

On a side note, should a rebound of oil happen at some point in 2016, one sure way of playing it would be through Fx via the Canadian Dollar (CAD) and/or the Norwegian Krona (NOK). 

Whereas, equities present more downside risk, credit has already significantly underperformed in recent month in fact as indicated by Barclays in their Oil and Gas monthly note from the 5th of January indicates the following:

"High Yield Energy Bonds Drop 23.6% in 2015 

The Barclays high yield energy index decreased 12.2% in December, the second largest monthly decline since 1991 (worst was October 2008 at -19.2%). This month’s drop leaves high yield energy down 23.6% for the year, underperforming the overall high yield market by 19.1% in 2015. In December, high yield energy credits moved lower because of a 12% decline in front month WTI and a collapse in natural gas prices to a low of $1.75/mmBtu on warm winter weather. By rating category, BB bonds returned -11.6%, B bonds returned -13.6%, and CCCs returned -12.9%. The independent index declined 18.3% in December, reflecting sharp decreases in the unsecured bonds of California Resources, Legacy Reserves, Vanguard Natural Resources, and Memorial Production Partners. Oilfield services dropped 8.4% on decreases in Seadrill, Atwood Oceanics, and CGG. New issue activity dried up completely in December, leaving year-to-date high yield energy issuance at $33bn, down from $55bn issued in 2014. 

Leverage Sensitivities and Breakevens at $40/bbl WTI 

We recently published an E&P update on leverage sensitivities and breakevens at $40/bbl WTI (report). In the report, we show sensitivities to debt/EBITDA in 2016 assuming $40/bbl WTI and $2.25/mmbtu Henry Hub, close to where strip prices are today. Two-thirds of the peer group has leverage north of 5.0x and five companies have leverage north of 10x (SandRidge, California Resources, MEG Energy, Denbury, and EXCO). However, hedging gains account for almost half of the peer group EBITDA in 2016, leaving unhedged debt/EBITDA at an average of 20x. Under this screen, 16 of the 27 companies we model have leverage north of 10x. Lowest leveraged companies under a $40/2.25 deck include Concho Resources (2.2x), Hilcorp Energy (3.2x), Baytex Energy (3.7x), and EP Energy (3.8x). Although not our base case, we note that Moody’s recently lowered its 2016 price forecast to $40/2.25, potentially foreshadowing additional ratings downgrades. 

Hedging Protection is Limited in 2017 

In our latest hedge study (report), we found that high yield E&P companies have protected 36% of 2016 oil and gas production and only 12% of 2017 production. While some high yield producers used the rally in oil to $60/bbl in May 2015 to fortify hedges, few producers have added to hedges in 4Q15 given the decline in strip prices. Almost half the peer group remains unhedged in 2017. As of 3Q15, we estimate that the peer group had a hedge book value of $12.6bn, with Antero Resources leading the peer group at $2.8bn. Top hedgers in 2016 and 2017 include Memorial Production Partners and Antero Resources, with an average 78% and 76% of 2016/17 production hedged, respectively. Credits with no hedges in place for 2016/17 include Goodrich Petroleum, MEG Energy, Midstates Petroleum, and Swift Energy. Energy Spreads Wider in DecemberIn December, energy spreads widened 292bp, to 1,296bp, compared with 58bp of widening for the overall market. December’s move left energy spreads trading 636bp wider than the high yield market, cheap compared with the 10-year average of 38bp through. The sharpest outperformance came in the oilfield services subsector, which widened as little as 5bp versus the high yield market." 

- source Barclays

Given the lack of hedges for some as reported by Barclays, should the "oil conundrum" continues, meaning lower for longer, no doubt to us that some players are going to face the default/restructuring music in 2016. 

This brings us to the second point of our conversation relating to credit and the current state of affairs.

• Credit - The credit cycle has turned and global financial conditions are tightening

While looking at the evolution of Global Fx reserves and their evolution since 2003 and in comparison with the recent periods, one being 2008 and the start of the rise in the cost of capital since mid 2014, if we use the evolution of these Global Fx reserves as a proxy for "global liquidity", one can ascertain that an expansion of these reserves indicates expansion, whereas a fall, indicates a global contraction - graph source Macronomics / Bloomberg:

One can notice from the above chart that during the financial crisis of 2008, between the 31st of July and the 31st of March 2009, Global Fx reserves tightened by 4.86% ($339 bn in 8 months, roughly $42bn per month). Since the 31st of July 2014 until the 31st of December 2015, Global Fx reserves have fallen by 6.39% ($768 bn in 17 months = roughly $45 bn per month). The on-going "liquidity" crisis, which is indeed a very big US dollar "margin call", is not only much bigger than in 2008, but, is lasting much more longer!

So even if some "pundits" tell you that at these levels High Yield is a "bargain", dear reader you should think again, although no doubt there are some interesting credit story out there (much more likely in Europe where leverage is lower), credit in the High Yield space continues to deteriorate in the US, hence our recommendation of moving higher in the rating spectrum for the last few months and favor Europe from a relative value perspective (better credit metrics).

When it comes to US High Yield we have to agree with Bank of America Merrill Lynch's take from their latest High Yield strategy chartbook from the 6th of January, "Winter is coming":

"2014 redux 

Last year was a lot like 2014, only amplified. Bigger oil slump, worsening fundamentals and gappier price movements in HY, more geopolitical turmoil, and higher EM volatility. These factors were already eroding investor sentiment within HY when the US economy also buckled, showing signs of a slowdown at the heels of an already faltering global economy. The news of liquidation of several HY funds due to mounting losses from distressed credits turned out to be the last straw, driving US HY to a return of -4.6%, its first negative annual return in a non-recessionary period. The only bright spot: mutual fund redemptions were comparatively much lesser last year (-$10bn) vs 2014 (-$21bn), which arguably gave US HY a level of support. Across asset classes, US HY was the second worst performer. Only EM equities underperformed more, while less risky securities such as Treasuries, Munis, and Mortgages were the best performers. Leveraged Loans outperformed HY returning -0.69bps despite the heavy outflows (-$25bn). 

Winter is coming 

It’s a binary world we live in: 2015 returns were heavily dragged down by commodities, outside of which the index was roughly flat (tab 1.01). Half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%). However, this dispersion doesn’t bode well for US HY, as our fears of valuations eventually catching up to fundamentals have not abated. Default and distress ratios are increasing, even outside commodities:

and while rating migrations ex-commodities have not reached 2011 levels, they are heading in the wrong direction. CCC issuance has plummeted (chart below) and the US-domiciled USD HY market has seen a net annual contraction for the first time since 2008:

We expect all of this to continue well into 2016, putting more pressure on non-commodity paper. In terms of opportunities, we think Fallen Angels will provide a unique one to HY investors in 2016 as demand for higher quality paper increases, especially in light of reduced primary market activity. We also like Leveraged Loans for many of the aforementioned reasons, and believe they will outperform bonds once again this year." - source Bank of America Merrill Lynch

2016, no doubt will be an interesting year for US High Yield particularly given the contagion risk, should market turmoils continue to run unabated as it seems to be the case so far. As displayed in Bank of America Merrill Lynch's data, not only leverage is higher than in 2008, but earnings have been falling faster in terms of EBITDA YoY changes:

Even Ex Energy earnings are falling...

We know nothing, Jon Snow 

Is it possible that the world remains in its current bifurcated state? Yes, if oil prices don’t bounce back and ex-commodity fundamentals don’t degenerate further. We can sympathize with the commodity bears given the levels of global oversupply, but corporate earnings power has been eroding for one too many quarters (charts above), and top cycle behavior has surfaced one too many times this past year for us to think that the corporate credit cycle has not turned. This is the foundation of our opinion that spreads have more room to widen from here, and a broader default cycle is looming, especially if outflows pick up. The more nuanced questions for 2016 and beyond however, include: what will be the direction of the global economy and how will that impact the business cycle back home? Will events in the HY market be enough to create another impediment for the US economy? Enough to turn the business cycle? The answers to these, we don’t know yet." - source Bank of America Merrill Lynch

So, don't push your luck dear reader, we might be breaking the fourth wall, but "overplaying" the "beta" game when the US credit cycle has turned is, we think asking for more trouble than "carry".

What we have long argued during the course of 2015 is that the more correlations were getting "positive" the higher the number of "sucker punches" aka large standard deviation moves. It is no surprise to us, that the year ended, for some bond holders of Novo Banco, with a bang as described earlier in our conversation. When it comes to 2016, given cross asset correlations have risen, we do expect even more "sucker punches" being delivered hence our mention of "risk reversal" opportunities in our last conversation of the year 2015. When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.

• Final chart - Correlations getting higher in a macro-driven market

We already discussed the rise in +/-4 standard deviations moves or more in various asset classes back in August 2015 in our conversation "Charts of the Day - Positive correlations and large Standard Deviation moves":

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations. Since the GFC (Great Financial Crisis), correlations have been getting more positive which, is a cause for concern" - Macronomics, August 2015

The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis. This is confirmed by our chosen chart from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 6th of January entitled "When credit met technical analysis":

"Correlations getting higher in a macro-driven market 

The credit CDS index market is a macro risk gauge. Post the global financial crisis and the subsequent central bank interventions, we find that pairwise correlations among different credits are now at a different (higher) regime (chart 4). 

Macro shocks (oil, Greece, China, EM risks, Fed, ECB) dominate credit markets. We see little prospect of the current market set-up changing in view of ECB QE.

Pairwise correlations across different asset classes have also been trending higher. Chart 5 shows the cross-asset pairwise correlations for equity, credit, implied vol and FX markets both in Europe and the US. Note that recently cross-asset correlations were at the highest level in a decade."

- source Bank of America Merrill Lynch.

Sorry to be breaking again the fourth wall dear readers, but, in our book, rising cross asset correlations is not a good sign for a smooth ride, but, at least indicates, there is convexity and risk reversal opportunities out there...and volatility is therefore a buy...

"A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune." - Horace

Stay tuned!