Two weeks ago, when looking at the performance of bank stocks, Deutsche Bank’s Oleg Melentyev noticed that the ongoing collapse in US bank stocks relative to the change in the S&P from all time highs was starting to hint at patterns last seen just before the last three major market crashes.
Needless to say, European stocks (and especially Melentyev’s own employer, Deutsche Bank) have been in a world of pain of their own. Which in turn brings us to Melentyev’s latest note, one which looks at a world without risk, courtesy of central banks.
A Riskless World
Only a few days into the post-UK referendum world, the market is back on its feet, fearing nothing and laughing at skeptics. So what if a 30yr socio-economic alliance at the heart of post-WWII world has ended? Politicians will figure out a Swiss-like arrangement for the UK, and the ECB will throw the capital keys out of the window. Everything’s gonna be all right.
Such an optimistic narrative does not surprise us in and of itself. What surprises us is zero value being put on a probability of this scenario not playing out. We tend to like markets that present either a discount for uncertainty or a convincing case for improving outlook. It is hard to argue that either one is here today. Even if one believes in the possibility of a watered-down political compromise between the UK and EU, pricing in zero risk of achieving and implementing it leaves no room for error. A long implementation time is not a benefit as it only creates more uncertainty. Several major EU economies are facing elections in the next 18 months, and the markets are going to react every time the word “referendum” is mentioned.
Another potentially weak link in the new narrative is its apparent reliance on strong monetary response. While some equity benchmarks are at pre-referendum levels, bond yields remained close to their recent lows, with 10yr Trsys -25bp from last Thrs, 10yr Bunds -20bp (at -11bp), JGBs -9bp (at -22bp). BOE is expected come out with some form of response two weeks from now, which is likely to have a local, and not global scale.
Who of the big boys of central banking can realistically make a difference here is unclear to us. The Fed was caught wrong-footed in all of this, between domestic news (weak non-farms) to international. It is unlikely to turn its thinking around right away. The ECB and BOJ are tapped-out; as in, their actions at this point are delivering more harm than benefit (underperforming equity and credit markets, lower credit issuance, substantial pressure on bank equities). Abandoning capital keys seems like another desperate move rather than a well thought out strategy. In China, authorities are already dealing with the consequences of reopening the credit spigot earlier this year that reinforced concerns of a credit bubble popping there.
Of all the markets, credit had arguably one of the strongest reactions to referendum results outside of FX, and has failed to reverse a substantial extent of it, at least as of the time of this writing. HY ex-commodity cash (DBHYSXC index) initially widened 68bps on Friday and Monday, or as much as it did in the first two days following Lehman bankruptcy, and it retraced 22bps on Tue-Weds, leaving it net 46bp wider for the period. An equivalent IG index (DBHGSXC) has widened out 10bp and retraced 2bps. We find this kind of reaction more reasonable than what happened in equities, but it’s hard to say if the rebound move is over or not. In the meantime, HY funds reported their 2nd-largest daily outflow on record on Tue (-$1.9bn, 2nd only to $2.7bn the day after Third Avenue). HYG put trading volumes have reached the highest levels since Dec as well.
So is the world really riskless thanks to central banks? According to DB (and it should know), the answer is a resounding no.
Fundamentally, we believe our case for the turn in credit cycle has gotten incrementally stronger following the events of last week. All market-based leading indicators we are relying on – from implied volatility to financials to AAs spreads to yield curve – deteriorated substantially over the past week, returning to their Feb levels (first three) or even exceeding them (the last one). Yield curves have also flattened globally on the week, with most major DM 10/2yr curve being 5-15bps flatter for the week, and 10-20bps flatter for the month. Japanese 10/2yr curve is at +8bp today, remains the flattest in the world, and also the flattest it has been in 25 years.
Other leading indicators, such as implied vol, AA spreads and financials, all touched on their mid-February levels over the past few days. We have previously described how low volatility coupled with receding stress in financials could, over time, work to fully neutralize the consequences of credit squeeze from Aug-Jan episode. As vol stays low, risk appetite returns, capital markets thaw, and the most vulnerable issuers get access to new financing. The longer it goes the lower the chances of incremental defaults. Recent events have probably reset that clock back to zero, meaning the lowest-rated issuers will once again face constrained market access for some time.
Aside from our market-driven credit cycle framework, an argument for slower global growth must be stronger today than it was just a week ago. UK could probably experience some form of a recession in the next year or so. It represents a 20% share in the EU GDP, so some impact is likely there as well. Whether it reaches US shores is an open question at the moment.
There is also a view out there that a sharp depreciation of GBP could prevent a recession in the UK. Such an opinion runs contrary to historical experiences. In the past, sharp GBP devaluations preempted but not prevented UK recessions, as was the case in 1992 and 2009.
Overall, we believe the events of the past week have made US credit a beneficiary of more money searching for yield, for longer. This is particularly true of non-US and globally-benchmarked money, which was previously looking at relative value between US and EU credit, for example. EU IG underperformed US IG YTD going into last week (+0.60% vs +0.95% excess returns), and EU HY underperformed US HY (+0.80% vs +1.6%). If EU credit failed to outperform in the early stages of QE and in a benign volatility environment, we find it hard to imagine how it can start outperforming from here.
Finally, and most ironically, if any other countries are thinking of following in the UK’s footsteps, the recent surge in UK stocks will hardly deter them from doing so:
Thinking about longer-term consequences of recent events, it is interesting to observe how UK assets are outperforming EU assets in recent sessions, including equities (Figure 7) and yield curves (Figure 8, UK’s yield curve flattened less than that in EU). If tail risk here is defined as other EU members considering an exit, datapoints like these are not helpful in arguing the case against such an outcome
Although is it really ironic? At this rate, by the time only Greece is left in the European “Union”, the S&P may be at 5,000 and rising on hopes and dreams that central banks will finally put money in everyone’s hands… with a “use by” date, and a provision said money can only be used to buy stawks.
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