I can’t help but get the feeling that the equity desks on the Street are increasingly isolated in their rosy outlook for markets.
Earlier this week, in “Epic Struggle Emerges At Citi As Stock Bulls Battle Matt King’s Bearish Credit Juggernaut,” we noted that the divide between Robert Buckland’s equity team and Matt King’s credit team has become so pronounced that the bank felt the need to document it in the introduction to their latest Global Asset Allocation piece.
In short, the credit folks are pretty concerned about what happens when we hit the “QE cliff” and private investors are forced to pick up where central banks leave off by absorbing some $1 trillion in investable supply. Meanwhile, the equity guys (and presumably “gals” if gender diversity is moving in the right direction) are laser-focused on the idea of a “synchronized global recovery”.
Indeed, Barclays used the same phrase (“synchronized global recovery”) in their most recent global outlook piece which carried the amusingly sanguine title “Hakuna Matata.”
Well, in yet another reflection of the growing disparity between the views espoused by the equity folks and the more cautious take emanating from the people manning the credit desks, Barclays’ US credit team delivered a pretty cautious assessment of markets in a note dated Friday.
You’ll note that what you’ll read below flags a phenomenon that should be familiar to readers: namely that credit is passed out with its head in the fucking toilet (i.e. ranges are ridiculously tight), which perhaps helps to explain why credit teams think things are a bit too quiet.
Additionally, do observe what clients think are the biggest risks to markets: US politics and the imminent rolling back of central bank accommodation…
2017 has so far been characterized by rallying markets in the face of political volatility – some drivers are behind us (such as the French election), whereas other events are developing (Trump policies, eventual Italian elections, Brexit negotiations).
Not only has performance been strong, but there have been very narrow trading ranges, in particular for US credit, with the current three-month trading ranges near the lowest for five years (Figure 1) across $IG and $HY, cash, and CDS. European credit has somewhat higher trading ranges currently, but this is more of a “luxury problem” in that it is only because of the rally after the French election and dovish ECB. Absent this rally, trading ranges in Europe are also near their lowest levels in years.
Spreads are near their tights across many markets, and volatility is low, buffered by respectable (although not exhilarating) economic numbers. What could possibly go wrong?
The reality is that there are many risks on the horizon as we write. The question is, of course, which of these have the potential to alter the stable picture materially for developed market credit.
Commodity volatility remains a key near-term risk for credit. While the market shrugged off the initial decline in oil prices, the move lower has begun to weigh meaningfully on credit performance. Since mid-April, as WTI prices have decreased 18%, high yield energy has returned -2.5%, compared with the 1.7% total return of the High Yield Index. Investment grade energy debt has similarly underperformed the index. A period of prolonged weakness in oil prices should drive more significant widening in energy debt, although the improvement in the sector’s fundamentals over the past year means that the downside will be somewhat limited compared with early 2016 moves. Nonetheless, given the significant weight of energy in both the Investment Grade and High Yield Indices, any weakness in the sector will have a substantial effect on index performance.
With that, a natural starting point is to focus on what investors see as the key risk to global credit markets, as per our recent Global Macro Survey.
The survey responses (Figure 2) show that US politics is the key concern, followed by withdrawal of monetary stimulus (Fed balance sheet reduction and ECB taper), whereas EM volatility and European politics are seen as less important.