Boy, the dour-sounding commentary on risky credit is coming in hot and heavy following a quarter during which HY spreads blew out by more than 200bp.
To be sure, there’s a lot not to like right now when it comes to high yield, with the most obvious risk also being the most general: the prospect of an imminent, deep downturn in the U.S. economy.
As usual, analysts generally tried to avoid coming across as overtly pessimistic despite the readily apparent market jitters, even if financial Twitter and the media were keen on sparking a panic.
At this point, though, the commentary coming out of Wall Street betrays a palpable sense of consternation. For instance, BofAML’s US HY strategy team is out with a new note called “Is This the ‘Big’ One?”, which, amusingly considering the topic under discussion, starts off with this:
Happy New Year everyone! We hope you had a chance to catch a good break over the holidays.
The very next line is:
Now is the time, in our view, to assess the situation and understand its consequences. Volatility shocks of this magnitude are quite rare.
Paraphrased: “Happy New Year everybody! Now let’s jump right in and ask whether the cycle is turning – hope you’re not hungover, because this will make you want to vomit!”
After quickly running through the recent malaise in equities, BofAML gets down to business in junk, noting that “about 12% of the HY issuers and 9.5% of index face value are now trading at distressed levels”.
The bank goes on to underscore something we’ve attempted to convey on any number of occasions lately: namely that the potential exists for a self-feeding dynamic to take hold in which sentiment ends up shaping reality, which then undercuts sentiment further and around, and around.
If you plug in inputs from last month into the bank’s default rate model, you end up with estimates jumping from 4.25% to 5.5% for the next 12 months and BofAML warns that “the extent of recent volatility, coupled with deterioration in investor sentiment, and tightening in financial conditions have increased the probability of a cyclical turn by a material extent.”
Again, this is self-fulfilling. The selloff in equities itself tightens financial conditions and the equity rout is doubtlessly attributable in part to investors scaring themselves to death – Trump isn’t helping by tweeting about how “the world is blowing up around us.”
BofAML goes on to list reasons why the cycle might indeed be turning, and exactly nothing on the list will come as a surprise. The bank cites (again) tightening financial conditions, the outperformance of utilities and staples, underperformance from tech and financials, the dreaded BBB “apocalypse” (they don’t use “apocalypse”, but you get the idea), years of loosening standards in the leveraged loan market coming back to haunt everyone, trade wars and monetary policy that is now constrained by the fact that normalization hasn’t yet freed up enough counter-cyclical ammo either in rates or on CB balance sheets.
On the bright side, the bank notes that their “default rate model estimate over the next year implies a material pickup in defaults but not necessarily a full-blown cycle.” They also cite reasonably healthy EPS growth expectations for 2019, a relatively slow debt/capex growth rate and, amusingly, the notion that because the energy mess in 2015/2016 was so recent, it “reduces [the] probability of another cycle developing shortly after.”
There are all manner of quotables from the full note, but the key point is the following passage:
While there are good arguments on both sides of this question, what gives us a pause here is the fact that the first list is dominated by events that are directly observable and unequivocal in their nature. The second list, on the other hand, is heavy in model estimates and historical parallels, which may or may not play out. Facts should be given preference over subjective observations, in our view.
Damn those “facts”!
No, but seriously, the other side of that argument is that there are myriad “facts” which support the notion that the U.S. economy is nowhere near recession, so you want to keep that in mind before you go jumping off any bridges.
— Sridhar Natarajan (@sridinats) January 2, 2019