Earlier this week, we talked a little but more about what Deutsche Bank’s Aleksandar Kocic has called the “hierarchy of vulnerability” for markets “at the intersection of politics and policy.”
The overarching point is that equities are on the front lines when it comes to what gets hit first from ongoing geopolitical turmoil and escalating trade tensions, but more interesting than that observation was perhaps the following bit from a client note making the rounds on Tuesday, several days after Kocic originally laid out the hierarchy of vulnerability:
While Implied/Realized ratios have been trading on top of each other, IG skew has been trading richer to its HY counterpart since the end of 2016, while IG vol continues to outperform HY vol pushing their ratio to new highs.
This seemingly counterintuitive result (IG seems to be more risky than HY) has a distinct “path-dependent” flavor. In the last several years, there has not been any significant defaults in the HY. With a long period of QE, most of the issues associated with HY have been perceived as the problem of the past. As robustness of the HY had been accepted, IG, at the same time, has become associated with macro-systemic risk.
On Wednesday, we cited several other sources and some posts of our own on the way to explaining how Kocic’s observation is consistent with a narrative that’s been running in the background for quite some time.
Specifically, we recalled excerpts from “Rise And Fall Of The ‘Zombies’” in which we cited a BofAML note on the way to underscoring the idea that QE has distorted the HY market beyond recognition:
Of course you can’t expect the investment community to “show discipline” in an environment where yield is an endangered species. The relentless chase down the quality ladder catalyzed by central banks dumping $15 trillion-ish at the top of that same ladder ensures that everything gets priced to perfection on the way down, with the sole exception of companies that are on the verge of default. Here’s schematic from Citi:
This raises questions about what happens when the accommodation that creates that dynamic fades or, more to the point, when central banks start to wind down their balance sheets. What happens to the zombies (so to speak)?
This is a pressing issue in Europe as the ECB tapers APP. So far, Draghi has demonstrated a propensity to lean on PSPP when it comes to shouldering the taper burden while keeping the CSPP bid largely in play. The Steinhoff debacle raises still more questions — that is, what happens if the ECB actually becomes an active seller of fallen angels while it simultaneously stops actively buying IG? Does that then set the stage for some kind of acute domino effect that causes spreads to blow out? More on that here and here.
BofAML recently revisited the zombie problem (see here for some highlights from their original exposition) and the following chart is extremely telling:
So obviously that’s the 6-month change in the Fed’s balance sheet against HY energy defaults and as BofAML notes, “as the rate of growth in the Fed’s balance sheet slowed to zero in March 2015, US high-yield energy defaults began to rise.”
Well, that brings us neatly to a new note from BofAML’s Barnaby Martin who suggests that the wind down of ECB QE will ultimately cause idiosyncratic risk to bubble (get it?) to the surface in credit markets.
To be clear, he’s talking about IG in the piece cited below, but the underlying message with regard to the effect QE has on suppressing idiosyncratic risk is the same.
Simply put, if what’s keeping spreads from widening out is the persistence of the central bank bid and the hunt for yield that bid creates, well then, the removal of that bid could very well mean that spreads on cyclically challenged sectors start reflecting the operating environment and/or that spreads on names that are getting stretched in terms of leverage start reflecting the fundamentals.
As BofAML writes, the equity market may actually be ahead of the game on this one, as highly levered European companies have been underperforming in the stock market:
Part of what you see there in the left pane is obviously related to Altice. “Recall that towards the end of October ‘17, the credit market had a wobble on the back of Altice volatility,” BofAML reminds you, adding that “the repercussions of this seem to be that the equity market is now taking a much more cautious stance towards companies that have above average leverage.”
Right. And there’s a lot of irony in that. Indeed, Barnaby Martin calls it “the irony of binging on debt” in the QE era. To wit:
We find the message of Chart 11 particularly revealing. In a QE world, companies have felt the ultimate freedom to issue as much debt as they have wanted. Expanding their Enterprise Values has not been a problem, as there has always been a willing buyer of their debt lurking in the wings (the ECB). But in a world without QE, such debt growth may not be so easily refinanceable. In other words, some companies may simply have become “too big” for the market to remain comfortable with. The irony of all of this is that debt growth is exactly what the ECB has wanted. CSPP has been the “carrot” that has motivated companies to debt-fund M&A and other shareholder-friendly measures. But the equity market now seems to be having second thoughts about the magnitude of this debt binge.
And so as we approach the end of QE later this year, we think investors should be mindful of higher idiosyncratic risk in names that have simply grown a lot bigger in such a short space of time. Who are these? Table 3 below highlights Eurozone IG non-financial issuers that have seen the largest percentage increase in debt outstanding since the start of ECB QE. Here we use all debt outstanding in ICE bond market indices. We also filter for names that currently have at least $10bn of IG credit market debt outstanding.
Ok, so again, that’s IG (not HY), but remember, CSPP sends everyone scrambling down the quality ladder, which means that the effect of the ECB’s corporate bond buying program is to prop up speculative grade issuers as well.
And indeed that’s what made the Steinhoff situation mentioned above and outlined in detail in the linked posts so vexing/hilarious.
In any event, you should probably keep an eye on this going forward as it’s just another scenario where you have to ask yourself whether it’s reasonable to expect markets to continue to be as forgiving when the QE bid disappears as they were when the QE bid was in place. In European IG credit, that’s an especially poignant question given that the ECB was literally supporting the market.