Credit risk inside the hall of mirrors

Risk sentiment likes the sound of a measured approach in terms of opening up economies. In broad terms, the recovery in equities rests on aggressive central bank policy that, for now, has limited strains in the financial system. 

Here, many look at the expanded purchases of corporate debt as playing an important role in soothing risk aversion. The flipside of such an extended presence is that central banks are locked ever more firmly in a hall or mirrors with markets, whereby prices are distorted and that ultimately entails a deeper reckoning for the financial system. The Hall of Mirrors scenario was raised by Ben Bernanke in 2004, and as recently as February, Richard Clarida, the Federal Reserve vice-chair, pushed back against such a relationship.

Earlier on Monday, the Bank of Japan kicked off a busy week of big central bank meetings, with an expansion of its bond purchases which includes quadrupling its purchases of corporate debt to ¥20tn ($186bn) until September 2020. This action from the BoJ will certainly have global consequences in that it likely pushes more money out of Japan and into higher-yielding foreign bonds.

Bank of America notes for example that US corporate debt, rated triple B and between a maturity of seven to 10 years, provides a yield around 2.88 per cent for Japanese investors once the currency risk is hedged. 

Another central bank upping its credit game is the Reserve Bank of India, via a new credit facility for mutual funds worth Rs500bn ($6.6bn). This comes after Franklin Templeton shut several funds, a move that trapped more than $3bn of investor money. Whether the RBI can stem the rise in corporate borrowing costs and higher default rates even before the arrival of Covid-19 looks tough. No surprise that the RBI said it would monitor financial markets and review the Rs500bn liquidity amount if necessary. Expect a bigger infusion.

Stabilising volatile credit markets is certainly required by central banks thanks to the vast rise in corporate debt in recent years and the prospect of rating downgrades that are a natural outcome due to a savage economic recession. Of course, prevailing low interest rates since 2010 explain why companies have piled up their debt loads. When the threat of higher borrowing costs threatens a company’s ability to refinance debt loads, the response from central banks is rapid. 

Against the great credit backstop, investors are seeking equities, but conviction is towards high-quality companies, not exactly a ringing endorsement that sentiment is truly bullish or that the worst is behind us. Buying the best in class among blue-chips reflects a view that these companies can survive revenue shortfalls today and bounce back a lot more than smaller rivals once the pandemic fades. By definition a quality company generates a high level of profits from a stable line of revenues and does not overly rely on leverage.

Here Oxford Economics highlights the performance in equity market styles, quality, value, growth and small companies: growth and quality lead the way and for all the hope of a rebound later this year, investors are not putting more of their chips on value and cyclical companies; at least not yet. 

Another quibble is that “tech sector valuations are now extremely stretched” says Oxford and they prefer “the more defensive quality sectors such as consumer staples and healthcare”.

US tech titans are certainly in the spotlight this week, with Apple, Amazon, Microsoft, Facebook and Alphabet due with their latest results and respective outlooks. A reminder, this select group accounts for one-fifth of the S&P 500, and drive the bus for the broader market. As noted previously, such concentrated leadership has not been seen since the internet boom at the turn of the century.

Morgan Stanley observes that big tech has benefited as earnings expectations for the broader market have collapsed. Ultimately, the bank’s equity strategists think:

“Once downward earnings revisions begin to recover, this cohort is unlikely to enjoy the same upward momentum from its higher base and that shift should unwind some of the market cap concentration.”

At this juncture, there are nascent signs that S&P 500 earnings forecasts are finding a floor, suggesting a peak is near for big tech relative to the broad market.

Bruce Bittles, chief investment strategist at Baird, notes:

“This has been a large-cap rally and will stay a large-cap rally until we see a rotation into the cyclicals, small-caps, financials, industrials and materials which will show the economy coming out of the current recession.”

Anticipating that rotation brings us back to credit. All the support from central banks has limited, but not eased, the pressure. Many in the market note how credit risk premiums for investment grade and high-yield corporate debt remain above their pre-Covid-19 levels in early February.

Now some of these wider risk premiums (certainly for investment grade) does reflect hefty sales of debt by companies, looking to refinance and/or move away from reliance on short-dated commercial paper. And keeping credit markets open — even at a higher cost for companies (Ford was a recent example, while Delta paid up on Monday) — is the rationale behind central banks backstopping credit.

Andrew McCaffery, global chief investment officer at Fidelity International, highlights the uncertainty around credit markets at the moment for investors tempted by higher yields. 

“Global high yield spreads had widened to an extreme of 1,100 basis points, but have since narrowed to 770. If you take that spread and back out a cumulative five-year default scenario, you get to a 20 per cent cumulative default rate. But there’s still a lot of uncertainty as to where the true rate is.”

Longer-term, the worry is whether the default cycle takes the form of a much harder landing that leaves central banks on the hook for losses and does not contain the fallout. Although in the case of the Fed, the US Treasury bankrolls the special investment vehicle that holds US credit purchases. 

Scott Minerd, global chief investment officer at Guggenheim Investments, argues:

“Fed purchases cannot turn bad debt into good debt. A buyer who is not careful can mistake Fed liquidity for credit strength and pay the price down the road when downgrades and defaults start in earnest.”

Quick Hits — What’s on the markets radar

Oil prices are falling sharply once more and it comes via forced sales of the current futures contract (June) for West Texas Intermediate, from the United States Oil Fund. The world’s largest oil-backed exchange traded fund says it will sell all of its futures contracts for the delivery of oil in June — 20 per cent of its $3.6bn portfolio — over a four-day period. The turning circle of a supertanker is enormous both on the water and in ETFs. 

Italian shares and bond prices are firmer in the aftermath of the country avoiding a sovereign debt downgrade late last week, but there’s also a market expectation that the European Central Bank will be very dovish at its meeting on Thursday. Closing the spread between Italy and German debt is the trade.