What Catalyst Could Trigger A Credit Risk-Off Event? Here's The UBS Answer
“What is THE catalyst?”
As all traders know, and as UBS repeats this morning in a new report by credit strategist Matthew Mish, one if not the mostly commonly asked questions is “what events could disrupt global corporate credit markets heading into year-end and early 2018.”
Also, as traders may or may not also know, until August corporate credit markets had experienced a prolonged period of relative stability since February 2016; empirically, the last time markets experienced 18 months in which US high yield bond spreads m/m failed to widen materially was back in 1992-93.
So, in an attempt to answer this most frequently asked question, UBS utilize two approaches.
First, it categorized historical bouts of widening going back 12 years (based on the US high yield synthetic spreads) to capture vol events in the largest higher beta segment of global corporate credit. Further, developed market spreads (US, European) are highly correlated across most time periods, suggesting this analysis is more broadly applicable.
Cumulatively, UBS observes approximately 42 months or 23% of the sample in which CDX.HY spreads widen more than 20bp (roughly equivalent to 3-month breakeven levels), with an average spread widening of 58bp. The Swiss bank then reviewed news headlines to approximately identify the root causes of the sell-offs.
In short, the key catalysts for prior sell-offs included US monetary policy tightening (#1), financial and sovereign crises (#2, 3), deterioration in US economic data and/or corporate profits (#4), geopolitical shocks (#5), oil price declines/ global growth weakness (#6), and credit-specific (more idiosyncratic) events.
Mish’s analysis then looks at the “qualitative perspective” of rising risk. Below the strategist discusses his core views across the key historical catalysts for spread widening episodes.
US monetary policy tightening: The Federal Reserve announced balance sheet tapering with implementation in October, but do not expect significant market volatility as UBS economists project a shorter and smaller unwind than consensus (with the balance sheet only declining from $4.5trn to $3.3trn in 2.7 years). However, Fed rate hikes are a bigger concern. UBS expects the Fed to hike in December and twice in 2018, while bond yields imply a ~60% chance of a December rate hike, and a similar likelihood of a second additional rate hike by December 2018. This is too low, given improving inflation dynamics (albeit from low levels) and easier financial conditions. This could pressure lower-quality US HY moderately (akin to the March sell-off) while reducing the attractiveness of US investment-grade credit for non-US investors (on a FX-hedged basis). Further, UBS also believes the nomination of a new Fed chair before year-end could create near-term volatility in markets. Mish notes that his client conversations suggest most are expecting little change in the status quo; that said, the nomination process has triggered material short-term vol previously (e.g., Bernanke’s candidacy in 2005 triggered a 20-30bp rise in 10yr Treasury yields).
EU monetary policy tightening: UBS also expects the ECB to announce tapering on October 26th to being January 2018. While the pace of tapering may be less than initially expected, given Euro strength, the direction of travel is clear. With deflation risks having dissipated, the ECB will have to reduce its asset purchases as PSPP issuer limits become binding. That said, like with the Fed, ECB tapering is now well-flagged. Hence, while clearly not a positive for European credit markets, it no longer creates the cliff which was feared previously. The ECB is expected to remain accommodative, be present in credit markets well into 2018 and rate hikes are expected in 2019 at the earliest.
Credit-specific risks: As the US credit cycle matures micro or industry-specific credit risks are increasingly relevant to monitor (e.g., telecoms in ’99, housing in ’06). Here are some specific observations from the UBS credit team:
US high grade and high yield markets currently exhibit material dispersion among industries, and similar divergences, while imperfect, can foreshadow pressure points and potential broader market weakness (Figures 4, 5). In HY the laggards are all service sectors – retail (702bp, 2.6% market weight), broadcasting (637bp, 3.2%) and oil and gas (555bp, 6.7%) vs. the broader market (388bp, 100%), reflecting pressures due to significant debt/ leverage growth and/or secular fundamental headwinds. In IG the outliers include telecoms (160bp, 5.1%), gas pipelines (172bp, 3.7%), and cable media (147bp, 3.5%) vs. the overall index (109bp, 100%), representing a mix of significant (long-dated) debt issuance and releveraging related risks.
In Europe, comparatively, IG spread dispersion is more compressed in part given the indiscriminate ECB bond buying across non-financial corporates (Figures 6, 7). While this could distort more idiosyncratic credit stresses, net leverage across bond market issuers is not overly concerning, especially given European issuers have had ample opportunity to re-gear balance sheets but thus far have not moved aggressively. We don’t rule out increased shareholder activism and M&A for IG firms, but we believe Europe is earlier in the credit cycle and more sector-specific events are less likely to be a primary catalyst for macro spread performance.
Oil price projections: UBS’ energy analysts expect oil prices to trade sideways (WTI at $47, $51, and $49 in Q3, Q4 and Q1’18) as the rebound in US production and uncertainty around the OPEC agreement has counterbalanced stronger global demand. The key downside risks include weaker global growth and a breakdown in the current OPEC/non-OPEC production agreement. Both scenarios, while not the bank’s base case, could push WTI back into the high $30s, triggering a material spread widening event.
China economic outlook: The material slowdown in China’s credit impulse is contributing to a slowdown in the property sector and import demand. However, alternative definitions of the Chinese credit impulse look more benign and one has actually bottomed. Recent data suggests recent property activity rebounded across the board, while retail sales, IP and FAI all missed expectations; this is consistent with a stable albeit slower economic backdrop, with real GDP expected to soften slightly to 6.7-6.8% this quarter vs. 6.9% in Q2. Shadow loan books remain a sleeper issue that is highly concentrated in regional banks and smaller joint-stock banks; while these loans pose potential contagion risk between banks, UBS does not conclude a systemic event is imminent.
US economic/earnings outlook: Fundamentally, at least on paper, global economic data has improved in recent weeks while US consumer and business sentiment remain elevated, even as inflation remains largely missing. ISM surveys continue to make new highs while corporate profits, even in the (revised) Q2 GDP report, showed a stronger-than-expected rise. Dollar weakness will also create a tailwind to US earnings by Q4’17 and Q1’18, boosting multinational profits. That said, earnings growth is improving but has not been broad based (ex- resource firms), the USD tailwind will accrue less to domestically focused firms (84 and 78%, respectively, of US HY and IG revenues) and firms on balance are not de-levering materially from near peak levels (Figure 8).
EU economic outlook: European economic data had a very strong performance in 1H17, and is expected to continue into 2H17, albeit at a slower pace. Eurozone GDP is to remain well above its trend in both 2017 and 2018 (Eurozone GDP is estimated to be 2.0% and 1.6% for 2017 and 2018 respectively), but slow from its highs of 2Q17 (0.6% q/q and 2.3% y/y). PMIs and corporate earnings momentum also peaked in May and are now stabilising and holding steady heading into 2H17 with 2017 on target to be the first solid profit growth in seven years (13% y/y consensus) but further Euro strength suggests potential downside risk to future earnings in non-domestic companies. Finally, European companies (excluding lower quality HY firms) are not re-levering balance sheets in similar fashion as seen in the US.
Furthermore, like Goldman last week, UBS which has a decidedly cautious bias toward credit has shifted its allocations within the space, but unlike Goldman, UBS is rotating away from IG and into HY: “we shift our preference for US high grade over high yield back to neutral on a total return basis as US yields normalize incrementally higher from current levels (YE targets: 10yr 2.4%). The narrowing in US high yield market vs. model spreads coupled with outperformance in US Treasury yields leaves us incrementally more positive on US high yield.“
In short: anyone hoping for a “gotcha” and a specific date with risk-off destiny will be disappointed because while UBS points out risks in general are rising – especially on the monetary policy front – it does not see any one explicit catalyst as launching an imminent risk-off event in credit markets. While the recent low-vol regime is certainly an outlier, and is now the most extended in a quarter century, absent a notable change in the status quo the Swiss bank is confident the current path will continue.