There are several arguments that one could currently make for why credit markets look unattractive. These include signals that the US economy is in late cycle, the fact that corporate leverage has been increasing (with 2016 setting a record for the amount of global bond issuance), and that US high-yield default rates have risen considerably through 2016, to their highest level since early 2010.
However, while there are many credit market specifics that could contribute to forming an unfavourable view on credit, our fundamental problem with markets is that implied volatility is far too low.
Importantly for bonds, changes in implied volatility are what normally drive credit spreads. It was possible to rationalise implied volatility being artificially low when all the world’s major central banks were extending and expanding quantitative easing (QE), but this is no longer the case.
In a recent blog post, we wrote about our scepticism over the huge reflation consensus narrative in the investment world. We also felt that too much optimism had been priced in regarding Trump’s pro-market/pro-business agenda, while seemingly ignoring the risks and negative aspects of his policies. Markets seemed to ignore the possibility that Trump may not be able to get all of his agenda through as planned.
Indeed, we think that – if anything – global political and economic risks have significantly increased since the autumn. Market pricing of this risk, however, has moved in the opposite direction.
The disconnect between global economic uncertainty and market-implied volatility is most extreme in credit spreads. While the Global EPU Index has risen sharply, credit spreads have actually tightened.
One can see a similar pattern in other measures of risk, such as the VIX Index (the option-implied volatility of options on the S&P 500). This is because credit spreads and equity market volatility are highly correlated. The chart below demonstrates the strong positive correlation between the VIX index and BBB credit spreads. In fact, the VIX Index closed, on Monday, at its lowest level since February 2007. As implied volatility rises, we should also see this drive credit spreads wider.
Since we wrote our last blog post, we have seen further unwinds of many of the Trump Trades, as investors become increasingly nervous about the US administration. The idea of Trumpflation, however, is alive and well, and investor nervousness has not spread to credit markets – yet.
One factor that has helped to keep credit spreads low is the ultra-accommodative monetary policy from central banks, such as the European Central Bank (ECB). However, the ECB appears to be on a path to reduce its purchases, while the Bank of England has stopped.
Source: Bloomberg, 01/01/2011-07/03/2017. Past performance is not a reliable indicator of future results.
Our concerns about political and economic uncertainty are global, but our focus is on Europe in particular. Europe bears so much of the upcoming political risk, notably Brexit and upcoming elections (way beyond France). The EU has a massive trade surplus with the US, and is therefore particularly vulnerable to Trump’s policies; this is very consistent with Trump’s anti-EU rhetoric. At the same time, concerns about European banks and Eurozone periphery economies are ongoing.
Banks have benefited from sharp steepening of Eurozone yield curves, but in a risk-off move we believe that core Eurozone government bond yield curves have the potential to flatten from what are now historically steep levels, which should put further pressure on European banks.
The Itraxx Sub Financial index is constructed from the Credit Default Swaps (CDS) of 30 European banks, equally weighted, with 1/3 of them coming from a combination of France, Italy and Spain. The index is highly correlated with periphery spreads, and is therefore we believe the best way to express our views on global uncertainty, political risks, European banks and European periphery risk.
While credit markets have become less worried about the French elections (and Italian politics), peripheral spreads have remained under pressure to widen. We have actually seen the Itraxx Sub Financial tighten year to date. Given that these tighter levels now imply a lower level of risk in the European financial system, buying protection on this CDS index is a relatively cheap and attractive proposition.
In a nutshell, the uncertain future path of monetary policy means that it is difficult to specify the catalyst that would cause corporate bonds, as the last ‘Trump Trade’, to start unwinding. However, at this level, any change in implied volatility would certainly drive credit spreads wider. Political factors, financial instability, the ending of QE programs and the materialisation of expectations for monetary tightening could all put pressure on credit spreads to widen.
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