Credit Market Daily #43

28-Oct-2022

Good Morning!

It is Friday, this is good.

What has changed?

• The ECB’s Owl comes across Dovish
• US GDP
• Meta Meltdown

ECB Hikes, Sounds Caution on Further Rises

We got the 75bp hike as expected.

What was unexpected was the ECB’s and Lagarde’s language. The statement removed reference to raising rates over several meetings.

Lagarde was more explicit – the Governing council will consider the inflationary outlook, the speed of transmission in monetary policy changes and the action the ECB has taken to date in deciding the rate hikes.

Further, Lagarde mentioned that they would consider the impact of declining growth/recession on inflation in their decsion making framework.

Money markets adjusted their hike expectations lower by -26bp and, government bonds rallied.

I think that the LDI “mini-crisis” may have given Central Banks a jolt – the system cannot take higher rates without some kind of financial earthquake.

See “What Caught our Eye” below for the latest Macro compass piece where Alfonso Peccatiello expertly breaks down the ECB meeting and its implication for markets and asset allocation.

As regards the start of QT Lagarde suggested that discussions would start in December. Monetary tightening will come in the form of raising the TLTRO rate making it less attractive for banks to hold on to their borrowings.

This saw Italian BTP spreads tighten significantly in celebration given their sensitivity to an outright shrinking of the ECB’s balance sheet.

The differential between the Italian 10-year BTP and 10-year Bund declined to 203bps from 220bps pre-meeting, with October wides being 243bps.

So, is a pause in the rate hike cycle on the cards? to paraphrase Alfonso’s analysis, the ECB are winging it.

Their bet is that inflation rolls over with a recession and as this plays out it allows them to moderate the pace of hikes.

This morning’s inflation prints from France and Italy in particular point to this being quite risky as a strategy:

“With this third major policy rate increase in a row, we have made substantial progress in withdrawing monetary policy accommodation”@ecb pic.twitter.com/YLYK9XmLkK

— Alberto Gallo (@macrocredit) October 28, 2022

Secondly, the ECB has a history of having to walk back messaging – there is a chance that if the market gets ahead of itself we will see the ECB temper any animal spirits.

This article from the FT also provides a good summary of events, and highlights that some in the governing council immediately questioned the markets’ interpretation of the presser:

“The fierce reaction, however, surprised some of the more hawkish members of the ECB governing council. “I don’t know what this is based on,” said one. “There are still lots of things to worry about inflation. If we keep getting high inflation readings, we will need another strong response.”

Martin Arnold, FT, 28-Oct-22

Net-net the ECB have certainly bought themselves optionality and I think that this is valuable, but the market tends to get ahead of itself – attempting to get to the destination without suffering the journey.

So, near term, the ECB may have created a sugar rush that will be followed by the inevitable comedown, or, worse given today’s CPI prints, appear out of touch and precipitate a comedown without any of the sugar high.

Medium-term, if inflation does play ball, lower rates should be supportive of risk assets and also push inflation expectations higher, further out.

See Alfonsos’ piece for the implications for asset allocation

US GDP – Bounce Back

US GDP rose 2.6% in Q3 higher than the 2.4% expected and up sequentially from the previous 2 quarters of negative growth.

Equity markets were mixed yesterday as the data inferred the FED would likely view data positively: their monetary policy was having the desired effect, but still supported additional rate hikes going forward.

One data point that really stuck out, especially after the 11% decline in home sales reported this week was the drop in the residential investment component -26.4% YoY, a testament to US mortgage rates’ meteoric rise

Consumer spending slowed to 1.4% down from 2% in the prior quarter, supported by spending on services +2.8% QoQ whilst spending on goods declined.

Meta Meltdown

Earnings have come to the fore this week with US tech taking one in the face and one in the chest.

Meta shares were down over 24% yesterday – an eye-watering c.$85bn being wiped off its valuation.

Apple bucked the trend with Q3 revenue coming in above expectations. See “What Caught our Eye” below for Bloomberg’s John Auther’s take on the subject.

Day Ahead

Earnings still abound and overall, tech aside, results appear to be ok – companies that have been able to pass through inflation have done particularly well Boparan for instance showing recovery in its meagre margins saw the bonds 5+ points higher on the day, McDonald’s beat on the back of menu price increases, Unilever increased its sales forecast for the year.

Today is less busy than yesterday in terms of earnings, but there are a number of interesting names on the slate – IAG, Air France and Punch Taverns to name a few.

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Credit

High Yield

High Yield enjoyed a positive week in terms of total returns (see table above).

Looking at spread performance moves were more nuanced with GBP HY underperforming on the week.

The European High Yield index spread moved -2bps (Z+608bps), -8bps on the week; The GBP High Yield Index moved +2bps (Z+770) +11bps on the week and lastly USD High Yield was -3bps (Z+493bps), -25bps on the week.

Using the 12-month spread Z scores GBP is the only index that has not become more expensive over the week with its Z score flat at 1.8.

European High Yield has seen its Z-score compress from 1.4 to1.29, and US High Yield looks to have moved from a relatively expensive Z score of 1.09 to 0.82.

Given this, I think GBP High Yield ought to outperform on a relative basis vs. Euro and USD high yield over the short term.

The lack of relative performance may be due to there still being some Fiscal Fiasco Factor being priced in GBP, but this has all but disappeared IMHO.

European High Yield Rel Val:

Sterling High Yield Rel Val:

Dollar High Yield Rel Val:

Leaders and Laggers

Investment Grade

The European Investment Grade index spread flat on the day (Z+224), -3bps on the week; the GBP Investment Grade Index was -1bp on the day (Z+230) and -7bps on the week.

Dollar Investment Grade was -1bp (Z+161bp) on the day and week.

Z scores US 1.47 vs. 1.63 EUR 1.54vs 1.68 GBP 1.58 v.s 1.82

In terms of Z-score Investment Grade became expensive across the board. With Euro Investment Grade moved to Z+1.54 from +1.68, USD IG moved to 1.47 from 1.63.

Sterling Investment Grade moved the most in terms of Z score, despite spreads being relatively flat on the week, from 1.82 to 1.58.

European Investment Grade – RV

Sterling Investment Grade – RV

Dollar Investment Grade – RV

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Rates

It was a mixed day in rates yesterday post the ECB with Gilts being the outperformer.

Bunds were flat and Treasuries underperformed post the positive GDP print.

This morning rates are giving back their gains – French and Italian CPI came in hot this morning at +1.3% MoM giving investors pause for thought post the “dovish” hike (oxymorons are now de rigueur when it comes to central banks).

We have German CPI later today.

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Equities

Having been mixed yesterday Europe and UK equities are opening lower on the back of the soft Tech numbers and hot CPI.

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Today’s Events

Eco Data

French, German, and Italian CPI and GDP, US PCE Deflator and University of Michigan Sentiment.

What Has Caught Our Eye

The Macro Compass – “A Sudden Change of Heart”

This is a comprehensive, coherent and well-communicated discussion of the ECB’s more cautious messaging.

I highly recommend you read or listen to the article.

Essentially Alfonso points to the inherent fragilities within financial systems that mean central banks appear to be taking a more cautious approach to hiking and what it could mean for asset allocation.

Bloomberg: “Wile E. Coyote Moment as Tech Goes Off the Cliff”

This is a great article in terms of providing context around the fall of Big Tech this earnings season.

“Coyotes can defy gravity for years in the markets — but generally there comes a point when the game is up. And this week has seen the FANGs (the acronym for the huge internet platform groups that originally stood for Facebook, Amazon, Netflix and Google when coined) respond to gravity at last.”

John Authers, Bloomberg, 28th-Oct-22

CEO Sentiment, UK Household Credit Conditions

Performance

High Yield

Investment Grade

Rates

Equities