Macro and Credit - Bouncing bomb

"To find relief in what has been, we must make ourselves eternal." - Violette Leduc French writer

While watching with interest the strong "relief rally" in commodities, High Yield credit seeing strong inflows as well as Investment Grade and equities alike, we thought we would this week again use an explosive analogy in similar fashion to our previous one. 

This time around our choice fell on the principle of the bouncing bomb given the strong rebound seen as of late in various asset classes. The principle of the bouncing bomb is as follows: The bomb is dropped close to the surface of a lake. Because it is moving almost horizontally, at high velocity and with backspin, it bounces several times instead of sinking. Each bounce is smaller than the previous one (in similar fashion to QEs, more on this in our conversation). The "bomb run" is calculated so that at its final bounce, the bomb will reach close to the target, where it sinks. A depth charge causes it to explode at the right depth, creating destructive shockwaves (market melt-down). 

Aeronautical engineer Barnes Wallis' April 1942 paper "Spherical Bomb - Surface Torpedo" described this particular method of "ricochet" attack in which a weapon (QEs) would be bounced across water (markets) until it struck its target, then sinking to explode underwater, much like a depth charge (asset bubble). This method was used during Operation Chastise in 1943 when the RAF's 617 Squadron attacked the Möhne, Eder and Sorpe dams in Germany with Barnes Wallis's "bouncing bomb. This Operation was re-enacted in the famous 1955 British film "The Dam Busters" starring Michael Redgrave and Richard Todd, based on the 1951 book of the same name by Paul Brickhill.

On a side note we find it amusing that a remake of the "Bouncing Bomb" has reportedly been in development since 2008, but has yet to be produced as of 2015. Maybe they are not looking in the right places, because if they would look more closely at financial markets, they would find out that the "Bouncing bomb" has been developing indeed since 2008 in the various iterations of QE but we ramble again...

Before we go into the nitty gritty of our Macro and Credit related conversation where we will discuss if this rally has legs or not and what to expect in the coming weeks and months, we would like to point out that in our short end of September conversation "A couple of charts summarizing recent credit markets violent moves" we clearly indicated that in credit a rally was on the card:

"Interesting entry points in cash bonds, if one believes in continuous Central Banks liquidity support and no recession. "

We also added:

"As we posited in our last conversation the US "releveraging" has been fast and furious  which is not yet the case in European credit (far less "leverage" and "buybacks").
Therefore on European Investment Grade Credit as well as European High Yield, we have reached some interesting "entry" points when it comes to "cash credit". This could be an enticing play for investors "gutsy" enough to "front-run" a buying spree from the ECB on a much greater spectrum of corporate bonds than just a few issuers (which so far have been included in their buying program)." 

While we mostly refrain from making direct trade recommendations in our musings, we do give once in a while "directional" hints that makes sense from our tactical point of view.

The rally seen so far in credit in both cash and synthetics has been confirmed in the rapid tightening seen in credit CDS indices since the roll on the 28th of September as reported by DataGrapple:

"Credit indices have tightened as fast as they widened after the roll. While they were 20% wider 10 days ago, the new series (25 in the US, 24 in Europe and Asia) are now roughly trading at the level at which they were issued 3 weeks ago." - source DataGrapple

While the "Bouncing Bomb" has been a welcomed "relief" for some, and given each bounce is smaller than the previous one, in this week's conversation we will look at the overall picture for Macro and Credit given the outcome seems more and more complex with a continuation of "sucker punches" or large "standard deviation" price movement such as recently witnessed in E.ON and RWE (up today by 9.87% and 12.78% respectively).

Synopsis:

• About the Emerging Markets (EM) rally: High Yield, particularly LatAm is still in the crosshair with Brazil leading
• Do we still believe the Credit Cycle is turning? A resounding, yes we do.
• Final charts - Looking for a Bouncing bomb? Tenfold increase in USD-denominated EM corporate bonds since 2009

• About the Emerging Markets (EM) rally: High Yield, particularly LatAm is still in the crosshair with Brazil leading

While once again the "Bouncing bomb" has done a nice "ricochet" as of late thanks to the Fed's holding pattern which is in effect suspending the "capital outflows" and "execution" for some, we believe that's this time around this "rally" doesn't have a lot of legs given, as per our previous High Yield related note, cost of capital is on the rise.

In September we saw a respite in terms of defaults in the EM HY space as reported by Bank of America Merrill Lynch in their EM Corporate Monthly report from the 2nd of October entitled "Living on a prayer":

"No defaults in September takes EM HY default rate to 3.3%
The EM HY corporate LTM default rate rose to 3.3% in September from 3.2% at the end of August, while the US HY corporate LTM default rate fell to 2.6% from 2.7% between
September and August. EM HY corporate defaults have picked up over the last year (the EM HY corporate default rate was at 1.9% at the end of Sept 2014) but remains contained and far below levels reached in Sept. 2009 (10.1%).

YTD, 14 EM corporate issuers have defaulted, which compares to just 9 defaults in all of 2014. On a trailing 12mo basis, there have been 18 EM HY defaults. Regionally, LatAm accounted for 7 defaults (6 from Brazil alone); 6 defaults in Asia (4 from China) and 5 defaults in EMEA. The regional LTM HY default rate as of the end of September was: LatAm HY 4.5%; Asia 3.6% and EEMEA HY 1.7%." - source Bank of America Merrill Lynch

Thanks to the Fed holding's pattern there is indeed potential for the "Bouncing bomb" to last until year end for EM credit and the high beta High Yield game, but, looking at the looming debt maturities, liquidity profile and FX exposure for some LatAm corporate debt issuers, rest assured that 2016 will not be smooth sailing. On that specific point we read with interest UBS take in their LatAm credit strategy note from the 9th of October entitled "Looming debt maturities, liquidity and FX exposure":

"Looming LatAm corporate debt maturities by country
LatAm corporates (including banks) have more than US$115 bn (according to Bloomberg) in debt (external and local) maturing in FY15 and FY16 of which about 55% is denominated in US$. The total amount due including FY17 doubles to US$230 bn with 56% in US$. Almost half of the debt due through FY17 is from Brazilian companies with US$113 bn, followed by Mexico with US$57 bn. Almost half of the Brazilian debt coming due is denominated in US$. While the US$ debt due in Brazil is large in absolute terms, the percent in US$ of total FY15-17 maturities from other LatAm countries is higher: Venezuela 97% of the US$16.6 bn coming due, Chile 73% of the US$16.5 bn, Peru 85% of the US$7.9 bn. We examine LatAm Corporates' upcoming debt maturities, certain potential liquidity issues, and US$ debt exposure.

Looming LatAm corporate debt maturities by issuer
The non-bank corporates with the most coming due in the near-term, as can be well imagined, include quasi-sovereign oil companies Pemex and Petrobras, followed by America Movil. See charts on page 2. Fortunately, liquidity ratios (LTM EBITDA + Cash / STD / LTM int. exp.) for these three companies are high at 7.2x, 2.8x and 3.5x (1H15), respectively, meaning they can all adequately meet their financial obligations at least through 1H16. Including financial obligations for 2H16 would lower Pemex' liquidity ratio to a still very high 5.8x, have negligible impact on Petrobras and lower America Movil's liquidity ratio to a still adequate 2.5x as it has US$2.75 bn coming due September 2016. Oi is next among LatAm corporates with US$2.8 bn due through FY16, but has a reasonable 1.8x liquidity ratio (1.6x including 2H16). The LatAm banks with the most coming due over the next five quarters are Santander Brasil, Bradesco and Itau with US$4.5, 3.6, and 3.4 bn, respectively.

Ten corporates (non-banks) with largest debt maturities FY15-17
The ten corporates with the most US$ debt coming due FY15-17 are PDVSA, Pemex, Petrobras, Cemex, America Movil, Oi, Braskem, Pacific E&P, Vale, Minera Frisco. CCR, Marfrig and Gasoducto Sur Peruano would be on the list if we exclude Quasi-sovs.

Foreign currency debt exposure
The significant depreciation in LatAm currencies has led to investor concerns related to exposure of LatAm corporates to foreign currency debt. Key issuers examined that are exposed to US$ debt without indirect hedges include Petrobras, CSN, Oi (although Oi mgmt states that foreign debt is hedged, but we would like confirmation on EUR debt), and Entel. Key issuers with minor FX mismatches include: Ecopetrol (which recently implemented hedge accounting), CMPC, BRF, Gerdau, Marfrig (0.7x in US$) and ICA. Key issuers with greater US$ revenues than debt exposure include Vale (13% of debt in BRL, hedges against weaker US$), Odebrecht E&C, Pemex. Finally, key issuers of bonds with balanced debt and revenues include: Fibria, Klabin, SCCO, JBS, and Minerva." - source UBS

So yes, while the recent "bounce" is enticing for investors to "carry on" or re-initiate the carry game which so far has been validated by recent huge flows seen in US High Yield, we do think that the risk, given the lateness in the credit cycle and credit game, does less and less justify the "rewards" or the exposure, particularly in a positive correlations world with larger and larger "Bayesian" price moves with significant Standard Deviations" (SD) impacts on the VaR models. Nonetheless, European leverage in the credit space is lower than in the US, which means European credit still appear to us more attractive from a relative value perspective.

In terms of US High Yield, ETFs have recently posted humongous inflows thanks to the Fed's holding pattern and as reported by Bank of America Merrill Lynch High Yield Flow Report from the 8th of October entitled "Record inflows into HY ETFs":

"US HY ETFs post largest ever dollar inflows
US HY had inflows of $1.16bn (+0.6%) for the week ended October 7th. This was driven by massive inflows into HY ETFs ($1.73bn, +5.3%), partially offset by a $574mn (-0.3%) outflow from non-ETFs. The enormous ETF inflow is the largest ever in dollar terms (although we saw a similar though slightly smaller $1.6bn inflow in July), and the greatest since December 2008 in percentage AUM. 

The massive inflows for ETFs were fueled by a big week for equity returns, where the S&P 500 gained in 4 out of the 5 trading sessions on the week. Non-ETFs on the other hand, posted outflows of -$574mn as global macroeconomic uncertainty continues to play out. High grade funds had a minor $315mn outflow on the week. The biggest loser this week in terms of %AUM was non-US high yield, which had a $3.65bn outflow (-1.5%). Loans had their 11th consecutive week of outflows, losing $337mn this week to bring their YTD total outflows to $14.30bn (-10.2%).
Other fixed income funds reporting flows were EM debt (-$639mn), munis (+$622mn), and money markets (+$20.87bn). In aggregate, fixed income saw a $3.01bn (+0.1%) net inflow this week. Equities, on the other hand, had net outflows of $4.09bn (-0.1%)." - source Bank of America Merrill Lynch

While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure.

As we posited last week in our conversation "Sympathetic detonation", our late credit cycle indicators are clearly indicating how late the credit game is:

"Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself." - source Macronomics

This leads us to our second point where we re-iterate our views that we are running late in the "credit" game thanks to "overmedication" from our "omnipotent" central bankers.

• Do we still believe the Credit Cycle is turning? A resounding, yes we do.

While last week we indeed mused on various metrics, particularly in US High Yield and the CCC bucket in particular being our favorite "Credit Canary", we would like again this week to point at other signs that indeed "something is rotten in the state of High Yield" to paraphrase Shakespeare's Hamlet masterpiece.

In the below Bank of America Merrill Lynch chart depicting High Yield/Loan New issue "Uses of Proceeds", you will see for yourself on continuation to last week where we highlighted the rise in Leverage and weakening EBITDA, that all is not well indeed in the "state of High Yield":

- source Bank of America Merrill Lynch

Whereas equity "monetization" is on the rise, there is no CAPEX whatsoever in the "Uses of Proceeds" from "new issuance". In fact Equity "monetization" in the High Yield space in the US has been on a meteoric rise since 2008 and cheap "credit" has also been largely used to push back to maturity wall to a later stage...

We could also point to another chart from Bank of America Merrill Lynch that clearly shows the deteriorating trend in US High Yield. For instance the chart below shows the trailing 3 month migration rate for US Investment Grade and US High Yield:

-source Bank of America Merrill Lynch.

And, when it comes to our "bold statement" relating to the lateness in the credit game, we would like to point out to UBS's take from their Global Credit Strategy note from the 7th of October entitled "Which firms could be shut out of capital markets?":

"Credit Cycle Turning? Non-Bank Liquidity Hits Multi-Year Lows
The recent sharp selloff in US corporate credit has amplified concerns about the staying power of the credit cycle. However, many investors point to a well-capitalized banking system and easy bank lending standards as a source of corporate strength and confidence in the current cycle. We believe this is insufficient in today's post-crisis environment. Non-bank credit dwarfs bank credit as a funding source for US corporates. The implication is that an assessment of the state of non-bank lending conditions is needed to gauge the health of today's corporate credit cycle. We utilize the bond market and trade finance as two areas where we can get timely reads on non-bank lending conditions, and both signal a tightening of lending standards ahead. Low quality speculative grade net issuance has fallen sharply in a replay of late 2007 as the stimulative effects of past Fed quantitative easing wears off. Non-bank trade finance has also decreased to its weakest level since September 2011. While bank lending standards currently indicate benign conditions, this may change in short order. First, Federal Reserve Bank lending standards are only available through Q2'15; it is likely that the summer market volatility has negatively impacted conditions. In addition, our proxy for non-bank lending has reliably indicated tightening bank standards for corporate borrowers in the past, with a one quarter lead. In short, we would expect bank lending standards to tighten through the end of this year. If our analysis is correct, today's elevated level of US investment-grade and high-yield credit spreads will persist, and default rates may rise materially through 2016." - source UBS

As we pointed out last week in our conversation "Sympathetic detonation":

"Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself." - source Macronomics

UBS also underlined in their report the significant fall in low quality speculative grade issuance and its similarity with 2007. In their note, UBS also made the following very interesting points which validates our early warning indicator being the "CCC fall in issuance level canary" depicted last week:

"The recent selloff in US corporate credit has amplified concerns about the staying power of the current credit cycle. Investors have been inundated with risk-off events over the past weeks, from falling commodity prices, weakening EM economies, monetary policy uncertainty, and increasing market illiquidity. Throw in rising idiosyncratic company issues across sectors from Glencore (Mining), Sprint (Telecom), Valeant (Health Care) and Volkswagen (Auto) among others, and it is clear that the latest selloff is different. This is not just an energy story, but a broader conversation about the credit cycle and our place in it (Figure 9).

Our framework for viewing the corporate credit cycle focuses on the supply side, as we believe the retrenchment of lenders from extending new credit is a reliable leading indicator of future refinancing risks for borrowers, as we discussed in Forecasting the Credit Cycle. On this note, banks do continue to ease lending standards, which has generally indicated lower credit spreads and default rates 6 months and 12 months forward, per our modelling work. However, there are concerns that a pure bank measure may be inappropriate for gauging the health of the corporate credit cycle in today's environment, given non-bank sources of credit, such as the bond market. US Non-Financial Corporate Bond Liabilities total $4.7tn vs. $0.8tn for Non-Financial Corporate Bank Loans (Figure 10).

Since 2008, the bond market has grown 57% vs. only 7% for bank loans. Simply put, tracking bank lending standards is not sufficient to gauge how the corporate credit cycle is evolving. Today is a case in point: Non-bank liquidity has fallen to cycle lows and points to a late cycle trend if volatility continues to rattle markets.

We utilize two timely measures of non-bank liquidity in this piece that have historically helped to predict the end of past credit cycles. The first comes from the bond market. We utilize changes in net issuance (proxied by Gross Issuance – Scheduled Maturities) for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. This is often the first clue that investors are shifting to a “return of capital” from a “return on capital” mindset. Our analysis suggests it is actually the lowest of low quality issuers (B-rated and below) that provides the first leading signal that credit stress may lie ahead, as Figure 11 illustrates. 

Worryingly, this chart is flashing red. While BB net issuance has held in quite well, B-rated and lower net issuance has plunged in a replay of late 2007, as investors cut back in the face of growing default risk and rising illiquidity. And stripping out the energy sector from this chart makes no difference; ex-energy low-rated issuance is drying up too. It is no coincidence in our view that HY issuance has struggled post the Fed's QE programs. Without the Fed injecting liquidity into the market, investors have been forced to focus more on credit risk, and they like less of what they see here. Even in terms of overall corporate credit creation, the US credit impulse (i.e. the change in credit growth) has been weakening for some time post-QE (Figure 12).

Importantly, this is not just a high yield bond story (Figure 13). 

The US loan market has seen a precipitous drop in issuance due to a Fed-led regulatory crackdown that began in 2013 to thwart the occurrence of poor underwriting standards (excessive leverage, absence of financial covenants, weak repayment possibilities). EM HY net issuance has also been on a downward trend since the end of QE3, raising concerns about how a looming maturity wall will be financed. Refinancing risks for speculative grade credits abound if this general trend lower in issuance persists.

Our second non-bank proxy is the NACM Credit Managers Index (CMI) on Trade Finance. This monthly index, constructed similar to the PMI index, gauges nonbank trade finance (the financing of receivables and inventories) from 1,000 US credit managers at individual companies and finance firms, rather than from banks (who are generally smaller lenders of this credit). September’s index reading dropped sharply from 54.2 in August to 52.9 in September, which represents the lowest reading in the survey since Sept 2011. There was broad weakness reported across both the manufacturing and service sectors, particularly with respect to debtor-creditor tensions (Figure 15). 

Invoice disputes rose, borrowers took longer to pay, and more lenders enlisted the help of collection agencies to collect on outstanding debt. While this survey is choppy month-to-month, its trend has been a good forward predictor of credit spreads; hence these poor results bear watching (Figure 14).

Previous readings of the survey from April to July had showed an improvement in conditions. We will need to analyse this data post-September to see if the recent down move continues to signal a worsening phase in tradefinance lending.

As mentioned before, the health of the banking sector appears reasonably strong at this juncture. Bank lending standards through Q2 ’15 remain solid and bank NPLs continue to decrease, with no sign of levelling off (Figure 16). 

This is a definite positive, but we worry it overstates the health of the credit cycle. First, bank lending data is lagged and only goes through Q2'15 at the moment. In the past bank lending standards have been reasonably correlated with the average VIX over the quarter; the official read on bank lending for Q3’15 may be less rosy than in Q2 (Figure 17). 

Second, the easing of Q2 bank lending standards was driven relatively more by competitive pressures than belief in a stronger economic outlook, as discussed in Do Improving Lending Standards Signal Hibernation For Credit Bears? At some point, acute loss risks will trump competitive pressures. Finally, even the well documented drop in liquidity for leveraged loan issuers was not picked up by the Fed SLOS survey, highlighting a potential blind spot in aggregate bank lending conditions.

What do our non-bank measures tell us about the future level of bank lending, and ultimately credit spreads and defaults, per our model framework? Utilizing quarterly data back to 2001, we build a model that predicts SLOS based on the level of the CMI index and low-quality HY bond net issuance (Figure 18). 

The fit is good (R-squared of 68%) as we expected, highlighting that bank and non-bank liquidity evolve similarly through time. However, we would note that our non-bank liquidity measure generally leads our bank liquidity measure by one quarter. The exception is during the financial crisis, where the banking sector was clearly the epicentre of the problem. The implication of this model is that bank lending will tighten from a healthy 6% of banks easing standards in Q2'15 to 14% of banks tightening standards in Q3 '15. This would be a significant move; these levels would imply HY defaults near 4.8% by Q3'16, even without accounting for specific stresses impacting the energy and materials sectors. Our fair value estimate for IG/HY spreads would be 183bps and 631bps by Q1'16 respectively vs. current spreads of 170bps and 684bps (Figure 19). 

In essence, while today's elevated spreads appear cheap, they only represent fair value. On the positive side though, we believe further spread widening would only be warranted with a systemic-type event, likely originating from even lower commodity prices, a renewed strengthening of the dollar, or a further deterioration in EM growth.

In sum, we believe that non-bank lending standards illustrate an overall tightness in US financial conditions that signal a downside growth risk to the US economy. While bank lending standards are healthy, we ultimately believe this misdiagnoses the pulse of the corporate credit cycle. Nearly all of the additional financing provided to nonfinancial corporates has come from non-bank sources, post-crisis. And expecting the banking system to meaningfully pick up the baton from a nonbank slowdown is unrealistic in today's highly regulated environment. In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating." - source UBS

Exactly!

There is indeed growing downside risk to the US economy thanks to rising overall tightness in US financial conditions but, we would add it is globally the case. The fall of EM FX reserves is as well a growing sign of tighter financial conditions.

So, overall, yes, clouds are lining up but when it comes to credit and the current "Indian summer" there is indeed room for additional short term spread tightening over the coming weeks. On that note we agree with BNP Paribas's recent take on this subject from their Global Credit Plus note from the 8th of October:

"Europe - Step it up

Given the FX moves in EM, we feel encouraged to stay constructive on European

Credit given the FX tailwind and potential upcoming ECB expansion. We dig a little deeper into our Leveraged Loans (constructive) and HY (less so) portfolio views this week. We recommend investors rebalance towards BB away from B in HY given the significant compression this year. We maintain our Overweight BB in Leveraged Loans. Supply should pick up moderately but given the basis underperformance we think Cash should hold its own relative to CDS. The Chinese Communist Party meeting needs to be monitored for any signals.

US - That old dog can still huntIn light of last week’s valuation move and the surprisingly weak nonfarm payrolls we have slightly revised our expectations for US Credit. We now expect spreads to tighten over the next 2-3 weeks before the combination of weak US corporate outlooks and unconvincing Chinese stimulus proposals reverse the trend. We also detail our expectations for Q3 15 US corporate earnings, including takeaways from early reporters and profit warnings." - source BNP Paribas

In the light of the above there are indeed more room for the "Bouncing bomb to "ricochet" a little bit further before sinking and triggering the collapse of the "credit" dam but that's another story...

For us, the BIS, our Rcube friends and now the IMF, a growing worrying concern has been indeed the significant rise in USD-denominated EM corporate debt.

• Final charts - Looking for a Bouncing bomb? Tenfold increase in USD-denominated EM corporate bonds since 2009

When it comes to a definite "Bouncing bomb", in similar light to the most recent IMF report, we still believe as per our previous conversation that indeed USD-denominated EM Corporate debt is the definite one as highlighted in the chart below from Société Générale Cross Asset Research note from October entitled "What if ? Lost decades":

"Emerging market corporate debt has exploded since the start of the global financial crisis. In its recently published report on Corporate Leverage in Emerging Markets, the IMF calculates that EM corporate debt has risen from less than 50% of GDP in 2008 to almost 75% now – with Chinese corporate debt alone rising from less than $8tr to more than $16tr over the same period.

So corporate debt has become the Achilles heel of the emerging markets. But the news gets worse. Emerging market corporates have not only borrowed aggressively – they have borrowed in dollars. A report from the BIS earlier this year made the point that most of the dollars created since 2007 have either been lent to the US government, or to non-US corporates – particularly in emerging markets. Both the BIS and the IMF reports make the point that corporate bond issuance has grown as a percentage of total debt. 

So it should come as no surprise that hard currency EM corporate debt has been growing by leaps and bounds. Chart 1 (based on the iBoxx USD-denominated hard currency debt index) shows the growth in outstanding dollar-denominated corporate bonds since 2009:

Three trends stand out:

• Total corporate debt has risen at a compound annual growth rate of more than 30% since 2009. The hard currency corporate debt market in 2009 was roughly the same size as the government market; it is now twice as big.

• Asian debt has risen slightly faster than debt in EEMEA and Latam, and now represents roughly two-fifths of the universe, up from a quarter in 2009. By contrast EEMEA debt have gone the other way, and Latam debt has stayed at one-third of the total.

• Chinese debt has ballooned to almost 60% of all Asian corporate debt, while Russian debt has gone from almost two-thirds to one-third of EEMEA debt. Brazil still represents between a third and two-fifths of all Latin American debt.

Is growth in corporate debt a worry? It has certainly boosted balance sheet leverage, as the IMF’s recent report notes. In Chart 2, we show the evolution of the debt/equity ratio from the companies in the iBoxx EM index.

The chart shows that balance sheet leverage has roughly doubled, and is now comparable to the levels in the US market (at 32%). The data from the start of this century is spotty, so we wouldn’t necessarily be sure about the magnitude of the increase – but the trend at least is clear. 

Nevertheless, part of the rise in leverage in the index may be due to changes in the index.

Charts 2 and 3 compare the composition of the iBoxx index by industry sector in 2009 and now.

Six years ago half the companies in the index were commodity and mining companies; now that percentage has shrunk to a third, with financials making up another third. The rather worse news is that cyclicals, which normally have low levels of balance sheet debt, have overtaken non-cyclicals, like telcos and utilities.

All the same, even with the changes in the index, the rise in balance sheet leverage is worrying. And given the focus in the press, i.e. supranationals and investors in the EM corporate sector, one would have expected this sector to lead the recent EM sell-off. But it hasn’t." - source Société Générale

One might wonder why it hasn't. Société Générale in their report had an interesting explanation tied to "liquidity":

"EM corporate markets are far less liquid than EM FX. As a result, EM investors could simply be selling the currency as a proxy for the corporate. In this case, the market’s woes could be just beginning." - source Société Générale

If indeed the Fed finally makes up its mind and finally decides to "normalize" we are indeed bound for more bouncing, more ricochet, before the EM USD-denominated Bouncing bomb set-off à la Dam Busters...

"With bombs and fires, you get only one mistake." - Red Adair

Stay tuned!

Macro and Credit - Sympathetic detonation

"I don't like to think that maybe I'm just getting old. I'm not too excited about watching a huge explosion. I'm more interested in people and characters." - Norman Jewison, Canadian director

Given the significant "blow out" in sovereign CDS spreads such as Brazil, the weakness in both cash credit and indices alike, with a continuation in the rout in Emerging Markets (EM) weakness, as well as the "Bayesian" price effect in the performances on US dollar denominated Emerging debt funds and weaknesses as well in "Total Return" funds, we thought this week's analogy had to steer towards the explosive one, hence our choice for "Sympathetic detonation".

A "Sympathetic detonation" (SD, or SYDET), also called flash over, is a detonation, usually unintended, of an explosive charge by a nearby explosion (in our case Emerging Markets). Sympathetic detonation is caused by a shock wave (think about the Taper Tantrum and the surge in Mack the Knife aka US dollar + US positive real interest rates), or impact of primary or secondary blast fragments. The initiating explosive is called donor explosive (commodities rout leading to Emerging Markets woes), the initiated one is known as receptor explosive. In case of a chain detonation, a receptor explosive can become a donor one, which is exactly what we are seeing in Emerging Markets and High Yield credit, particularly in the Energy sector which will no doubt lead to defaults and restructuring, rest assured.

We find our title analogy appropriate given that in a "Sympathetic detonation", detonators with primary explosives are used (surge in the US dollar and collapse in oil prices), the shock wave of the initiating blast (Taper Tantrum) may set off the detonator and the attached charge (Emerging Markets). However even relatively insensitive explosives can be set off if their shock sensitivity is sufficient. Depending on the location, the shock wave can be transported by air, ground, or water. The process is probabilistic, a radius with 50% probability of sympathetic detonation often being used for quantifying the distances involved. Often "Sympathetic detonations" occur in munitions stored in e.g. vehicles (mutual funds), ships (hedge funds), gun mounts, or storage depots (dwindling EM FX reserves), by a sufficiently close explosion of a projectile or a bomb. Such detonations after receiving a hit can cause many catastrophic losses (such as the ones received recently by investors in various asset classes except cash, still being "king" in a deflationary bust scenario). What we are seeing playing out, is of course what we warned about since 2011, namely a currency crisis, which is the wave number 3 we have discussed in numerous conversations.

Just remember this, before we dive into our conversation, from our credit perspective and in relation to our chosen analogy even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely.

Major equity / Credit divergences should always be taken very seriously to quote the Guest note from November 2014 from our good friends at Rcube Global Asset Management  entitled "US Equity / Credit Divergence: A Warning".

Whereas our friends were probably a little bit too early in their call, we think that the recent significant deterioration witnessed in Credit and in particular US High Yield (a subject we have discussed at length during this summer), is for us, and some others, showing that the credit cycle is indeed turning and taking, we think, a turn for the worse. 

In this conversation, we will again point out to a worrying instability sign we have indicated, namely the impact of positive correlations leading to "Bayesian" price movements. On that subject we would like to refer to our August post "Positive correlations and large Standard Deviations move".

While typing this very note, we mused on twitter with our estimate for Nonfarm payrolls at 155K 30mns before the number came out. Given our recent blunder in hoping the Fed would hike by 25 bps in September thanks to us succumbing to "Overconfidence effect", we decided to opt for the "contrarian effect" which this time around came to fruition as NFP came out with a miserable 142K, putting us firmly back in the "deflation" saddle thanks to our US long duration exposure (partly via our ZROZ ETF exposure) as well as our long gold miners exposure which suddenly sprung back to life. 

Synopsis:

• Increasing correlation between asset classes is leading to instability and weighting on diversification - are inflation linked-bonds a solution?
• In US High Yield this time is not different.
• Final chart - Correlation to Oil very positive and unusually high

• Increasing correlation between asset classes is leading to instability and weighting on diversification - are inflation linked-bonds a solution?

As per our August post "Positive correlations and large Standard Deviations move",  the rise in +/-4 standard deviations moves or more in various asset classes can be solely attributed to rising positive correlations due to central banks meddling with asset prices.

As a reminder:

"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

For us, there is no "Great Rotation" from "bonds" to stocks" there are only "Great Correlations".

This can be ascertained from the graph below from Société Générale Special Report published this month and entitled "The virtues of inflation-linked bonds":

"The past two quarters have been characterised by an increasing correlation between asset classes and between equity and bonds. Diversifying a portfolio is becoming more difficult. On the other hand, in a context where inflation should gradually normalise in the next quarters, inflation-linked bonds bring some diversification benefit.

In the broader picture, on a historical basis, inflation-linked bonds have become quite correlated with other asset classes lately, in line with increasing average cross-asset
correlation.

The US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme, bringing more diversification benefit (see chart in margin).

"The correlation between inflation-linked bonds and nominal bonds has increased significantly in recent years, particularly as themes such as secular stagnation, deflation and even Japanification of the economy are still part of the economic newsflow. The current low growth and low inflation environment has made inflation-linked bonds and nominal bonds move in tandem since 2013. As discussed earlier, we have decided to introduce inflation-linked bonds into our portfolio by giving a maximum weight to US TIPS. US TIPS look attractive not only on a valuation basis, but they also provide lower correlation to other developed markets nominal bonds compared to UK peers." - source Société Générale

Whereas in their long and interesting report Société Générale make the case for using inflation-linked bond as another layer of diversification and in particular US TIPS, we have to agree that given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor".

Unlike TIPS, gilt linkers do not have a "deflation floor" protecting the cash flows from deflation, hence the current favorable attractiveness of US TIPS. But, in similar fashion, French government issues inflation-linked Obligations Assimilables au Trésor (OAT) bonds, which reference either a pan-European inflation index (the Euro-Zone Harmonized Index of Consumer Prices excluding tobacco (HICP)) or a French inflation index (French CPI ex-tobacco) also feature a "deflation floor" in that the principal face value and coupon payment can never decline below the value at issuance. Swedish linkers as well provide a similar deflationary protection feature as per the table below from Pacific Alternative Asset Management presentation from the 3rd Quarter 2011:

"US Inflation-Linked Bonds
The largest market for inflation-linkers is in the United States, where the US government issues Treasury Inflation Protected Securities (TIPS). TIPS feature protection of principal and interest payments from inflation. The principal, which is payable at maturity, is linked to changes in the non-seasonally adjusted Consumer Price Index for Urban Consumers (CPI-U). The semi-annual coupons on the bond are also inflation-adjusted since they are based on the underlying inflation-adjusted principal amount. Notably, the bonds also feature a ‘deflation floor,’ as the amount owed on the notes can never fall below the original face value of the bonds. This floor also applies to the coupon, which can never decrease below the stated coupon rate at issuance. The floor is an important component that can protect investors against prolonged periods of deflation." - source PAAMCO

Indeed, in a prolonged period of deflation, such as the one we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets.

When it comes to gauging the risk in rising deflationary trends, the US Deflation hedge premium has been rising significantly recently as displayed in the below Bloomberg chart via @boes_ on twitter:

 - source Matthew B -  @boes_ on twitter

Furthermore, the global deflationary forces have been gathering steam as well as displayed in the below Gavekal Graph:

- source Gavekal

World CPI is falling, not a good indicator and no matter what central bankers are telling us, they are inept at re-igniting the "inflation" genie so far.

Furthermore, the US 10 year government bond market is pricing more and more a deflationary/quasi-recessionary picture:

- graph source Bloomberg

Post NFP data, we have broken again the lows on the US 10 year.

How can there be a recovery and a rise in "inflation expectations" when Average Hourly Earnings MoM are flat and Average Hourly Earnings YoY are growing at 2.2% when the market was expecting 2.4%?

This is proof that the US much vaunted recovery is weaker than expected.

Also the Atlanta Fed has revised its GDP outlook, On October 1, the GDPNow model forecast for real GDP growth in Q3 2015 is 0.9%. Many sell-side economists who also got their NFP call wrong (99 of economists polled by Bloomberg in fact) still suffer from "Overconfidence effect" when it comes to their US GDP growth expectations:

- source Atlanta Fed

Could the Fed really hike when US breakevens are falling rapidly, which is clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing - graph source Bloomberg  - Robin Wigglesworth on Twitter

-graph source Robin Wigglesworth on Twitter

In September as well, Europe has clearly shown it was moving back into the dreaded "D" territory with the latest Eurostat Eurozone MUICP coming at -0.1% - graph source Bloomberg - Holger Zschaeptiz on twitter:

- source Bloomberg - Holger Zschaeptiz

Or, maybe you call this a recovery? 
Bloomberg graph displaying the Unemployment-to-Population Ratio vs Unemployment rate - graph source Bloomberg - Michael McDonough

  - graph source Bloomberg - Michael McDonough

Back in September 2012, in our conversation "Zemblanity",(Zemblanity being defined as the inexorable discovery of what we don't want to know), we discussed the relationship between credit growth and domestic demand and why ultimately our central bankers will fail in their useless reflationary attempts:

"credit growth is a stock variable and domestic demand is a flow variable"

We even asked ourselves at the time the following question:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

What we have long posited is that while wanting to induce inflation, QE induces deflation.

This is what we discussed in March this year in our conversation "The China Syndrome". At the time, we quoted CITI's Matt King's 27th of February note entitled "Is QE Deflationary":

"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI

No wonder Société Générale thinks US TIPS are enticing from a"diversification" perspective. They are not enticing because they are "cheap", they are enticing because of the "deflation floor" embedded!

The lack of evidence that consumers are spending what they are saving on gasoline should also start to concern investors.

Stronger USD leads to higher deflationary risk leading to lower long-term bond yields (that's what we are playing right now). Even though exports are only 13% of the US economy, 40% of S&P 500’s earnings now come from outside the US.

Given that "cheap money" went to fuel "overcapacity" hence the "commodity bust" and that as we posited earlier on in our conversation "cheap money" has to be paid back sometimes, the recent price action in US High Yield is exactly telling you that is becoming increasingly unlikely. This brings us to our second point namely that in US High Yield this time is not different.

• In US High Yield this time is not different.

Back in July in our conversation "Mack the Knife", we discussed High Yield in particular and the scary CCC Credit Canary as an advanced early indicator of a deterioration in the credit cycle. No offense to the "macro tourists", "carry players" and "beta gamblers", but, we think that in US High Yield, this time is not different, it is worse.

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

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

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

In September our "CCCs Credit Canaries" underperformed all else with a return of -3.2% while Bs were at -3% and BBs at -2%. All HY sectors posted negative total returns on the month.

At the time of our July conversation we did read with interest UBS's take in their Global Credit Comment from the 27th of July entitled "The scary reality":

"The problem, however, is some of the tourists underappreciate the exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle turns annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range (versus $83 currently) - especially given expected recoveries average in the $20 - $25 context. The scary reality is those investors in triple Cs are seeking high single digit returns when they are likely to end up with negative total returns over the next several years (if our view of the credit cycle proves correct)." - source UBS

For us there are several ways of assessing the deterioration of the "credit cycle" from the US High Yield perspective. One of these ways is very simple, it is looking at the percentage of CCC issuers able to access Primary markets. 

The below chart from Bank of America Merrill Lynch from their October High Yield Credit Chartbook clearly shows that less and less CCC issuers are able to "tap" investors in the primary market:

"Are we there yet?
Let’s take stack of how far we’ve unwound in September. US HY has backed up a 100bps to 670bps, yields have broken into the 8 handle, and retail has pulled out at least another $1bn from mutual funds. At current levels, HY spreads are pricing in a 6.5% default rate for the overall market, and 4% on an ex-energy basis over the next 12 months. So, is it time to buy yet? To tackle that question, we don’t have to look too far. In 2011 when there was fear of a global contagion, yields reached 9.8%, and ex-commodity spreads 900bps. Yes, the source of contagion was different (Greece and US downgrade then vs commodities and EM now) but the transmission mechanism is still the same- investor risk aversion. And where we are today is arguably worse than where we were then from a credit standpoint because HY earnings then were better, leverage was lower and USD was weaker. Low quality issuers were still able to access the market and we had the Fed easing. Today, not only is the Fed in normalization mode, but the proportion of CCC issuers that have managed to access the market on an LTM basis stands at <20 font="" nbsp="">a far cry from the peak of 52% two years ago. Looking back, the periods when access to liquidity for lower quality issuers was this poor and going in the wrong direction, was in 2008, 1999 and 1989, just ahead of each default cycle (Chart above)." - source Bank of America Merrill Lynch. 

Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself.

Another illustration in the newsflow in investors "waning" appetite has been ALTICE SA which was only able to raise €1.61 billion in capital increase out of the €1.8 billion it was seeking to pay 60% in cash for the acquisition of US Cablevision. Also, it had to pay more in terms of coupon to entice bond investors in its latest bond placement for the rest of the funding for its acquisition as reported by the Wall Street Journal on the 28th of September entitled "Investors Pull Back From Junk Bonds":

"Altice on Friday sold $4.8 billion of junk bonds to fund its $10 billion purchase of Cablevision Systems Corp., according to S&P Capital IQ LCD. When the deal was shopped earlier this month, Altice expected to sell $6.3 billion of debt, investors said.
A 10-year bond was priced to yield 10.875%, compared with yields as low as 9.75% that were suggested by bankers initially, according to S&P Capital IQ.

Olin on Friday sold $1.2 billion of bonds to pay for its pending acquisition of Dow Chemical Co.’s chlorine-products unit. Earlier in the month, Olin was expected to sell $1.5 billion of bonds, fund managers and analysts said.

The annual interest rate on Olin’s 10-year bonds sold Friday was 10%, up from 7% expected earlier in the month, according to S&P Capital IQ. The steep increase in yield reflects growing concerns that slowing demand from China could hit sales of chemical makers." - source Wall Street Journal

ALTICE SA's total debt amounts €45 billion (including Cablevision). It represents nearly twice the turnover and 5.7 times gross results for the group whereas the average for the sector is around 2 to 3 times.

Back in June 2015 in our conversation "Eternal Return", we indicated that for us M&A activity was the last sign we were getting late in the credit cycle à la 2007. This is as well confirmed by the same Wall Street Journal article quoted above:

"Companies have announced $3.2 trillion of M&A this year, according to Dealogic, emboldened to merge by cheap debt and the long stock rally that began after the financial crisis. That puts 2015 on pace to rival 2007 as the biggest year ever for takeovers. Issuance of junk bonds backing M&A deals hit a year-to-date record of $77 billion through Friday, according to data from Dealogic."

A souring of investors on junk bonds could limit the availability of financing for deals that require a lot of borrowing. Banks have been under pressure from federal regulators to reduce their loans to such companies, and a pinch in the bond market could leave those deals struggling for financing." - source Wall Street Journal

Yes, dear readers, time to adjust to reality, this time it is not different and cost of capital is going up. Trade accordingly.

When it comes to High Yield, yes default risk matters, but more importantly, to repeat ourselves from our previous conversations, change in "earnings" as well. In the below Bank of America Merrill Lynch charts, you will see for yourself that not only is leverage higher Energy sector included or not, but, the YoY percentage changes in EBITDA growth have taken a turn for the worse. This is not a good harbinger for things to come in High Yield going forward. Caveat Creditors...

US High Yield Net Leverage (Net Debt/LTM EBITDA, X)

US HY EBITDAs, YoY Percentage Change

US HY Ex-Energy EBITDAs, YoY Percentage Change

US High Yield Cov-Lite Issuance as a percentage of Market Size

- source Bank of America Merrill Lynch

Contagion spreading from the Energy sector to other sectors in the High Yield market? Lower credit standards? Higher leverage? Weaker earnings? You bet!

If this time for US High Yield is not different, at least the latest sell-off compared to the one experienced in 2011 is "different" as most credit metrics are weaker. On the subject of the difference in the latest sell-off, we read with interest UBS's take in their Global Credit Comment entitled "US HY: This selloff is different":

"US HY: This selloff is differentThe speed and magnitude of the recent US HY selloff has caught credit investors offguard and captured the attention of the broader market. Spread widening of 46bps over the last 2 days1 was the worst seen since October 2011, leaving the overall market at 689 bps, 216bps wider than June 1st. Naturally, clients are asking what has changed and what is causing the selling pressure. Many would assume that credit markets are being hit with substantial retail outflows, leading to forced mutual fund selling. However, in context, the recent outflows are not commensurate with the spread widening experienced. From June 1st to yesterday, HY spreads widened 216 bps on $11.4bn of retail mutual fund outflows. Interestingly, from Sept 1st, HY spreads widened 97bps on effectively zero mutual fund outflows. This lies in stark contrast to prior recent selloffs during Taper Tantrum (+57bps on $12.8bn of MF outflows, Jun- 2013) and last summer’s swoon (+87bps on $21.6bn of MF outflows, Jul-Sept 2014). This begs the obvious question: What accounts for the greater severity of today’s price action vs. the prior two years?
---
At the core, we believe fund managers are aggressively raising cash in anticipation of a structurally more volatile and dangerous environment. Investors are no longer only experiencing the pain of mark-to-market pricing on their portfolios, but they are becoming acutely aware of downgrades and default risks emanating from falling commodity prices, weakening EM economies, and rising idiosyncratic risks. This fundamentally-driven selloff is also laying bare the problems of illiquidity, through the default-driven liquidity channel as we wrote about in “A Primer on Corporate Bond Liquidity”, Oct 2014.
---
In short, investors are internalizing that we are in the late stages of the credit cycle. We have seen aggressive cash-raising in the past when investor sentiment has shifted so rapidly, using the VIX as a proxy for overall risk appetite. There is a reasonably tight correlation (0.62) between HY fund manager cash balances (%AUM) and the average monthly VIX level through time (Figure 1). 

We indeed have also seen an increase in cash balances already, from 4.25% in May to 4.75% in August, bringing cash balances to the highest levels since February. We think future cash balances in September and beyond will easily surpass that seen earlier this year. Using a linear regression based on the relationship between cash balances and the VIX, we expect HY cash balances to increase to 6.5% of AUM in September. This would be consistent with cash levels seen in 2010/2011, during the depths of the Eurozone crisis.
---
Hence, we believe today’s selloff is fundamentally different than that experienced during Taper Tantrum and last summer’s swoon. Both of the latter selloffs, despite having larger retail outflows, saw little cash raising by funds (Figure 2). 

In fact, during last summer, cash balances were actually drawn down, which limited the impact of these outflows. This is consistent with the fact that overall risk sentiment did not shift enough for fund managers to change their behavior; the VIX during both episodes remained subdued. This is not the case today.

Another factor we may be missing is institutional outflows, which may be moving first, with retail outflows to follow later. Anecdotal comments abound that the bid for lower quality paper is not what everyone had envisioned. While we will not get preliminary Q3 data on institutional third-party flows until later in October, there is evidence that the institutional bid, once very solid during Taper Tantrum, is starting to waver, as we saw last summer (Figure 3). 

Even in Q2 ’15, there were more institutional outflows than during Taper. We would expect to see further evidence of institutional outflows based on this trend. What is our prognosis going forward? This is a re-pricing of fundamental risk as the market transitions to a more volatile environment. As our equity colleagues detail , this risky environment is likely to persist due to a structural shift in monetary policy (from easing to tightening) and rising credit risks and losses. The result: Higher HY fund cash balances should be the norm for the foreseeable future, making the prospect of a significant tightening in spreads unlikely. On the downside, there is a clear risk that a further reduction in risk appetite would trigger significant retail outflows on top of funds raising cash, which would greatly exacerbate spread widening and illiquidity. However, if volatility stabilizes, even at these high levels, incremental cash will be put to work as investors tread carefully, leading to a slow grind lower in spreads from today’s elevated levels. In the shortrun, absent a further leg down in commodities, we would expect this grind lower in spreads to occur as the market is moderately cheap by our model estimates. Over the longer-run though, the downside risk of an outflow-driven selloff looms in the background." - source UBS

Of course, when it comes to outflows, there has been indeed a materialization of the "Sympathetic detonation" from the commodity rout, as reported by Bank of America Merrill Lynch in there High Yield Flow report from the 1st of October entitled "Here come the outflows":

"Significant outflows from high yield and loans
Amid the slowly worsening global macro backdrop, we saw a flight from risk assets into relatively safer areas this week. US high yield reported $1.5bn in outflows (-0.74%) for the week ended September 30th, which is the largest weekly outflow from the asset class since July 1st. The brunt of it was borne by ETFs, which saw -$809mn leave, while the remaining -$700mn came from HY non-ETFs. Loans reported $605mn in outflows (-0.61%), making it the worst performing asset class YTD, having lost 10% in AUM. Second worst YTD are EM bond funds, which realized outflows for the 10th week in a row, -$1.35bn (-0.52%), and now stand at -5.3% in terms of AUM lost YTD. High grade funds had a more modest $1.84bn outflow (-0.2%). The only fixed income classes recording inflows were munis, with $260mn (+0.1%), and money markets with $2.16bn (+0.1%). In aggregate, fixed income funds lost $3.57bn (-0.18%) to outflows on the week. The last week in which fixed income had more than $3bn in outflows was June 17th (-$4.17bn).
Other funds reporting outflows were equities (-$452mn) and non-US high yield (-1.49bn). Commodities and money markets recognized inflows of $268mn and $2.16bn, respectively." - source Bank of America Merrill Lynch

But High Yield and Emerging Markets have led as well to some other detonations as reported also by Bank of America Merrill Lynch in their Follow The Flow note from the 2nd of October entitled "Equities show outflows symptoms":

"Credit and equity fund flows – all negative
Market stress has been reflected in European fund flow data. Following a week of rising idiosyncratic risk outflows hit both credit and equity funds.
Outflows from high grade funds more than tripled from the previous week; and are now at four weeks high. The withdrawal from high yield funds quadrupled w-o-w as the asset class recorded their second biggest outflow of the year. Last week’s cumulative outflow from credit funds was the seventh in a row and the highest in four weeks. Credit ETF fund flows have also dipped into negative territory.
Equity funds inflows seem to have run out of steam. While the recorded outflow was only marginal, it remains indicative of a change in the trend. Note that this is the fifth week of the year where the asset class displays a negative flow number. Global EM debt funds continued to see more outflows; recording their tenth consecutive week of outflows. The asset class has suffered the most year-to-date with close to $15bn of outflows.
Commodities fund flows remained negative even though the outflow was not sizable it was the fifth week of continuous outflows.
The exception this week was European government bond funds, which posted a positive inflow, the first in six weeks. The asset class endured close to $7bn of outflows since the bundshock back in April." - source Bank of America Merrill Lynch

 If this is not indeed a "Sympathetic detonation", then we wonder what all of this is! In terms of initial blast (collapse in oil prices and surge in the US dollar), the shock wave has indeed set off the detonator in the credit market and the attached charge (leverage). This leads us to our final chart which once again shows how central banks meddling in asset prices leads to "unusual high correlations" with oil prices. 

• Final chart - Correlation to Oil very positive and unusually high

While we started on the impact of positive correlations leading to "Bayesian" price movements which have been "abundant" as of late and a clear sign of "instability", our final chart comes from Morgan Stanley Credit Companion note from the 18th of September entitled "Focusing on the Fed, and Correlating with Commodities":

"US IG Credit Spreads:

Since we hit the double-digit tights of June 2014, US IG spreads have widened to 163bps over the past five quarters. This 60% jump in spreads stems from several factors at the management level which include increased buybacks, higher than expected issuance, and a heavy M&A pipeline (see Credit Continuum: The Buyback Bonanza, April 28, 2015 and Credit Continuum: M&A Makes Its Mark, June 10, 2015). However, the macro environment has also played a large role. Market volatility remains elevated as a result of macro growth concerns, and plunging oil prices have had a major impact on the Energy sector and to a lesser extent, the Basics sector.

Oil vs. Major Asset Classes:

Earlier this year, our Cross Asset and Commodity teams noted that recent correlations between oil and US High Yield have been unusually elevated, and have only been this high once before, during the peak of the 2008/09 crisis (see Cross-Asset Dispatches: Are You Just Trading Oil?, August 16, 2015). Certainly for IG, the story has been similar. 

- source Morgan Stanley

You can expect additional "Blue Mondays" going forward, more "Bayesian" price movements (+/- 4 standard deviations) and even higher positive correlations courtesy of your "local/global" central banker. This of course will lead to yet a bigger "Sympathetic detonation" to 2008, but that's another story and as any good story teller tells you: "To be continued..."

"Our duty is to believe that for which we have sufficient evidence, and to suspend our judgment when we have not." - John Lubbock, British statesman

Stay tuned!