Needless to say, I’m a big believer in the idea that the market isn’t properly pricing political risk.
I think the best expression of this is probably in FX vol/equity vol ratios which are sitting at or near highs across markets. As you’re well aware – if you frequent these pages – my foundational theory on markets in 2017 is that FX vol is going to dictate the action and that FX markets are going to become increasingly beholden to politics.
That said, it’s certainly not just equities that are mispriced. Credit is pretty damn rich as well, especially speculative grade names which have benefited from 12 months of spread compression, the rapidity of which borders on the absurd.
I talk mostly about US credit because the little heat maps that I see on the site dashboard suggest that the Heisenberg Report is first and foremost a US phenomenon (with designs on conquering the rest of the world, of course). But let’s take a moment to look at € credit.
SocGen is out with a pretty bold forecast (well, it’s not really “bold” if you’re on the same page regarding how complacent the market has become) that puts Xover at 725bps by the end of June. That’s a ~425bps blow out in the space of just ~4 months! And can you guess what the catalyst is? That’s right, political risk.
Here some excerpts from a what I think is a pretty damn good note.
There are more issues than the usual credit cycle factors and this year we will have to deal with more political risks than previously. The first one is Brexit and so far the rhetoric from both sides is less than conciliatory. When the results of the referendum were announced, the iTraxx Main index jumped from 75bp to 98bp, and cash as measured by the iBoxx Corporates index widened by 17bp, despite the CSPP bid. However, the effects didn’t last more than a few days, in large part because the imminent departure of the UK was postponed. Now the market has had time to prepare better, but we still expect volatility to rise once the actual negotiations start. It’s not for nothing that sterling has lost so much ground.
Additionally we have the Dutch elections and particularly the French elections. At the moment, the far right seems set to make it to the second round and given their stance on eurozone membership, we expect the market to be nervous in the run up to the vote, irrespective of what the polls may say. Finally, we have the first days of Donald Trump’s presidency and so far the markets have priced very benign policies with US equities hitting record highs only a few weeks ago. The risk is that there will be some disappointment and risk aversion continues to take hold of the markets. In that sense, we believe that the cards are stacked against credit in the first few months of the year.
With cash widening by around 40bp, we see the iTraxx Main widening by around +50bp to 120bp by the end of 2Q. Now the XO/Main ratio has been stuck at around 4x for a long time (since 2015) and we don’t think this is too sustainable. In fact, we believe that as the tone deteriorates, and yields rise, the appeal of HY, and the X-Over in particular, will be lower than recently and the ratio should go up towards the 6x level. This is nowhere near as unprecedented as it was over 5.5x in 2015 and prior to the crisis it was at 10x.