Credit Market Daily #32 %author %

07-October-2022

Good Morning!

The first week of Q4 is nearly over – what have we learned?

I think the main takeaway as we head into the Q3 reporting season is that credit fundamentals remain under pressure and are expected to soften from here.

See CMD 31 for the corporate distress index and CMD 30 for default expectations.

This has yet to filter through to credit spreads and will likely mean we have a drift wider in spread terms.

Q2 earnings were relatively solid, but we are seeing the first signs of weakness with profits being guided down and cost-cutting exercises being announced, the extent that Q3 confirm this will determine how quickly spreads move.

Governments announced support for businesses and consumers is in place and represent a cap on what will be a 25-50% increase in energy costs.

Gas prices in Europe have bounced off the lows and Oil prices are expected to squeeze consumers at the pump bringing energy inflation to the fore again if Goldman Sach’s forecasts are anything to go by.

Consumer and business sentiment remain at the lows and Economic data, PMIs, and ISMs point to a slowing global economy with the UN and IMF expecting a global recession and the FED delivering a soft landing improbable.

In terms of valuations – credit has some way to go with European and Sterling High Yield Credit indices some 7% off their Pandemic wides and US High Yield 5.8% off its wides ( See CMD 27).

Investment grade spreads are even further from their Pandemic wides in spread Euro, GBP and USD IG 12%, 21% and 57% respectively.

So from a credit perspective, we should be entering an earnings trough in Q3’22, Q4’22 and Q1 ’23.

Lower margins and higher leverage should be the catalyst for cost savings, debt paydown and healthier balance sheets.(S&P comments it is seeing signs of debt paydown in the US already, see “What caught our Eye” below)

These are all the things a credit investor loves, coupled with peaking in rates over the same time horizon the opportunity for strong returns is very real.

We just have to get to the trough relatively unharmed and that means risk aversion.

With government yields in the front end attractive there is every opportunity to have your cake and eat it.

In credit, it means short-duration, BBB/BB-rated paper.

Credit “stories” with clear positive catalysts, avoiding refinancing risk (see CMD 29), favouring non-cyclical – over cyclical, Secured over Unsecured debt and large capital structures with access to funding (both debt and equity).

Equities have yet to adjust to any “new normal” and are very much hoping that the “old normal” will be reinstated.

We have seen that technicals are such that a strong rally is a real possibility, but the fundamental outlook and central bank messaging could not be any clearer.

Credit

High Yield

Week to date, European, Sterling and Dollar indices have returned +97bps, +91bps and +195bps respectively.

They look like they may well hold onto this gain absent Non-Farm Pay Rolls that are interpreted as hawkish by the market.

In terms of performance on the day, High Yield outperformed rates-driven Investment grade but was down on the day.

European High Yield returned -15bps on the day with higher beta single Bs underperforming BBs a reversal of the performance seen earlier in the week with BBs returning +111bps on the week vs. Single Bs returning +83bps.

Given the current uncertainty, most investors will be sheltering in the safer BB space.

Sterling High Yield returned -20bps on the day whilst US High yield bucked the trend and was up +14bps on the day outperforming both investment grade and equities.

It will be interesting to see if it can continue to decouple from the other 2 asset classes, but I suspect this is a blip.

In CDS Xover widened 6bps on the day to 613bps, for context the European high yield Index’s spread was 5bps tighter putting the basis Xover-Cash spread back into positive territory.

Leaders and Laggers

In single names, Eastern European credit United Group saw its bonds lower on the back of a European bank and hedgefund selling, with no specific news flow, highlighting the illiquidity in the market.

Similarly, cyclical Progest (Paper) and Oriflame (Retail) were down without any newsflow.

On the positive side of the ledger – Metal Corp bonds rallied significantly post a management call which gave investors more detail on how the company was planning to move forward. S&P moved the company to Selective Default.

Investment Grade

Year to date European, Sterling and Dollar Investmentgrade have returned -16.47%,-25.13% and -18.08% respectively.

For context the Euro Stoxx 600, FTSE 250, and S&P 500 have returned -18.75%, -24.91% and -21.44%.

Rates have been a wrecking ball for Investment grade credit and we likely have 3-6 months more volatility as Central Banks, Inflation and a weakening global economy look to find an equilibrium.

In spread terms, we have yet to touch pandemic wides (see CMD #27) – so whilst all-in yields are attractive it pays to stay defensive – short-dated, non-cyclical and avoiding potential falling angels.

See CMD #24 for the relative value of BBBs vs BBs and CMD #25 for the number of GBP IG bond issues trading at a cash price below 80.

There is value to be had, but without a move wider in credit spreads fundamentals remain a risk to be managed.

Rates

Rates ended the day wider in Europe, the UK and the US.

The 10-year Treasury, Gilt and Bund Yield 383bps, 415bps and 208bps respectively.

Gilts were wider on the back of a BoE survey that showed firms were expecting wage growth increases to be offset via price hikes, and front-end gilts rose above 4% again as the market reversed prior bets of a lower terminal bank rate.

Equities

It was a risk-off day with European bourses down between -40 and -80bps, the FTSE was down -78bps.

Week to date The FTSE, DAX and Euro Stoxx 600 are up +150bps, +294bps and +219bps respectively.

Whether they hold onto those gains depends upon today’s NFPs.

In the US the S&P, Dow Jones and Nasdaq returned -102bps, -115bps and -68bps respectively.

At the time of writing futures point to a soft open with indices expected to open down between -30 and -70bps.

Today’s Events

Eco Data

We have had German Retail sales -1.3% MoM, -1.2% expected. German Industrial production -0.8% MoM vs -0.5% expected.

Later we have Italian retail sales and US Non-Farm Payrolls.

Today’s reporting

None.

What Has Caught Our Eye

BoE – Price Hikes to Offset Wage Rises

This article from the FT comments on the BoE’s Chief Financial Officer’s survey and serves as a counterpoint to the IMF article I flagged yesterday, which highlighted the risk of inflation expectations de-anchoring as one scenario that would prevent a wage-price inflation spiral from taking hold.

‘The findings confirm BoE concerns “that firms are finding it too easy to pass higher costs on to consumers”, said Simon Harvey, head of foreign exchange analysis at Monex Europe, a foreign exchange company.
Harvey noted that the more hawkish members of the MPC will consider this “de-anchoring of medium-term inflation expectations as particularly concerning” ‘

Businesses are expected to increase prices by 6.6% in the next 12 months up from 6.5% a month earlier.

2/3rds of respondents said their concern for their businesses was whether high or very high. and a separate British Chambers of Commerce survey showed 40% of businesses warning that their profits would be lower in the next 12 months.

The headlines around the survey were the driver for the move higher in Gilt yields yesterday.

US Companies pay down debt in Q2’22 – a bigger ask for High Yield

Standard and Poors report that companies are paying down their debt rather than refinancing as of Q2’22.

As mentioned earlier Q2 earnings were relatively resilient and Standard and Poors also flag that this means companies are entering Q3 in a relatively healthier shape.

You can clearly see the difference between Investment Grade and Non-Investmentgrade companies, with investment-grade companies having the spare cash to put to work, with high-yield companies’ debt-equity ratios flat or increasing.

S&P have handily put the sector moves in a GIF so you can see the changes at this level below:

Median Debt to Equity Ratios Fell sequentially in Q2 – IG 88.6% from 90.1%, HY 123.4% from 125.4%

Median Interest Coverage Ratios Rose in sequentially Q2, IG 9.1x from 8.4x, and High Yield 4.5x from 4x.

What EV says about Equity Valuations:

Market cap is one thing, but Enterprise Value reflects also net debt 👇 Relative to sales we have just arrived at the top of the 2000 dotcom bubble. (Goldman Sachs) pic.twitter.com/BTFSlY03oA
— Michael A. Arouet (@MichaelAArouet) September 29, 2022

Credit Market Daily #32