Where are markets underpricing the myriad risk factors that currently cloud the outlook, from developing economy turmoil, to Italian fiscal risk to trade war jitters?
Well, certainly in U.S. equities, which are still hovering near all-time highs despite ongoing chaos in EM.
The disconnect there makes at least some measure of sense. After all, the same factors that are contributing to EM turmoil are also buoying the U.S. equity market. Late-cycle fiscal stimulus created a buyback bonanza stateside and also helped corporates report record profits. But that same stimulus is keeping the Fed on edge, and the explicit hawkish lean in the hikes and implicit hawkishness in their communication with markets, have pushed the dollar higher, weighing heavily on developing economy assets.
European equities seem more in tune with reality than their U.S. counterparts, especially in financials and autos, which are under immense pressure.
Well, in his latest note, BofAML’s Barnaby Martin flags what he thinks are some pretty severe disconnects in CDS compared to surging EM FX vol.
“We think the CDS market is under-pricing the current plethora of risks out there”, Martin says, in a note dated Monday, adding that in BofAML’s mind, “the upcoming CDS index roll has been a key driver of the current ‘apathy’ of the CDS market to the slowing PMIs, the rising EM FX vol and the weakness of the cash market, especially in the high grade space.”
Here’s what he means by “apathy”, first in Main:
(BofAML)
Then in CDX HY and Xover:
(BofAML)
Just how historically anomalous are these disconnects? Pretty anomalous, actually. In fact, the decoupling between Xover and EM FX vol. looks unprecedented, at least going back to 2010. As Martin notes, “the magnitude of the recent decoupling” is something to behold:
(BofAML)
BofAML goes on to flag an extremely rare decoupling between the correlation of CDS spreads and EM FX vol. and EM FX vol. itself, illustrated rather poignantly in the following chart:
(BofAML)
“Note that back in H2 2015 in the previous EM FX sell-off there was a ‘lag’ between the EM market stress peak and the CDS market reaction”, Martin continues, adding the obvious, which is that if history is any guide and “EM volatility continues, [one] struggles to see CDS markets tighter.”
But look, if you doubt this assessment – i.e., if you think it makes sense for credit spreads to remain suppressed in spite of their traditional relationship with another risk proxy like, say, EM FX vol., well then you can sell yourself some protection via a brand new ETF called “The Tabula European Performance Credit UCITS ETF”, ticker TCEP.
What does that do, you ask? Well, it sells protection on a basket of European IG and HY issuers on behalf of retail investors, because you know, what could go wrong with turning “mom and pop” into credit derivatives traders?
For the privilege, you’ll pay 50bps and if you’re wondering why in God’s name anyone would create a product that allows retail investors to sell default protection on a basket of credits they doubtlessly know absolutely nothing about, Tabula CEO Michael John Lytle has this to offer:
Specialist credit managers can isolate and manage credit risk using credit default swap indices. This is a liquid and efficient market, but it isn’t accessible to all asset managers.
Right. And there’s a reason for that, Mike.
