Credit Market Daily #40

25th October 2022

Good Morning!

With Rishi uncontested, the UK will have a new PM by midday and a cabinet shortly after.

As Hunt expected to remain the Chancellor, he will deliver his budget (with accompanying OBR forecasts) on the 31st ahead of the BoE’s meeting on the 3rd of November.

Normal service has resumed, although the Bank of England was quick to point out that the markets remain “febrile” and any real turnaround in credibility will require a follow-through:

“Credibility is being recovered, at least on that benchmark measure, but that has to be followed through..stability around policymaking and around the framing of fiscal events will be really important”.

Dave Ramsden, BoE

Markets reacted positively to the swift resolution – Gilts moved around -24bps tighter in the front end,-27bps in the belly and up to -30bps in the long end.

With most of the heavy lifting done with positive catalysts out of the way, we must look forward to what will be a sobering budget and economic outlook on Monday.

Sunak earned a reputation for being supportive of consumers and businesses during the covid crisis. He won’t be able to spend as he did back then and with the cost of living crisis coming back to the fore and a fiscal balance to plug, he has a much trickier task to deliver on both.

In terms of the Fiscal Fiasco Factor (FFF), as you would expect, this improved across the board and now the question is where does it settle?

Markets overshoot and a giveback of some of the rally seems likely as markets wait to feel the fibre of Sunak’s fabric.

As you can see – the only measure yet to fully recover is the Gilt-Bund Spread. The difference between the UK and German CDS spread of 3bps now sits below the 5-year average of 5bps.

So credibility looks to have overshot in CDS terms, whilst the Gilt Bund spread appears a little more pragmatic in its appraisal.

Measure (bps)	FFF Peak	Mon 24th Oct	Change	Spread 5-Year Average	Current Spread Z Score
UK CDS – German CDS Spread	25.5	3.6	-21.9	5	-0.26
10 Yr UK Gilt – 10 Yr Bund Spread	227.5	141	-29	100	2.03
10 Yr UK Gilt – 10 Yr BTP Spread	-15.9	-84.3	-23	-68.4	-0.14

PMIs point to further economic contraction

Yesterday’s PMI data was soft, with France the only country whose composite PMI did not point to contraction.

Overall numbers came in below survey expectations and added fuel to the “Fed will slow the pace of hikes” rally that continued on Monday.

Central banks are likely to continue hiking for the next 3-6 months, data like the PMIs will give them pause for thought, but they all seem to agree that overshooting and killing inflation is a lot less costly than taking the foot off the gas and letting inflation remain.

The main takeaway is that earnings and credit spreads are likely to be pressured further as any slowdown gains pace. (See what Caught Our Eye below)

Regional Composite PMI	Oct Actual	Oct Survey	Sep Actual
UK	47.2	48	49.1
US	47.3	49.2	49.5
Euro Zone	47.1	47.6	48.1
Germany	44.1	45.5	45.7
France	50	50.2	51.2

PMIs vs. GDP Growth:

---

Credit

High Yield

High Yield underperformed both equities and Investment Grade yesterday, less impacted by the move-in rates.

In terms of spreads, European High Yield was flat on the day at Z+616. USD High Yield’s spreads tightened -5bps on the day (Z+512bps) as equities rallied and treasury yields tightened on the possibility of a reduced pace of hikes.

The Xover index was -17bps, and is opening a further -3bps tighter this morning at 582bps. Given the basis Xover-Cash and its use as a hedge, this outperformance makes sense.

GBP High Yield actually saw its spread widen +18bps (Z+777bps) to levels seen last Tuesday. As with last week’s move, I would expect some lag in terms of the index spreads so let’s see where we settle at the end of the week.

Despite the move wider in spreads, the GBP index returned +58bps on the day with the heroic move in Gilts offsetting the implied negative excess return.

It is a big week in terms of earnings. This morning we have 10+ names reporting this morning and this will hopefully mean that we see fundamentals come to the fore in what of late has been a macro-driven market.

Very, for instance, reported positive numbers, revenue grew 12.6%, Group revenue was up 4.8% vs. pre-pandemic FY20 and EBITDA margin rose 0.6% on the back of cost-cutting initiatives.

Keep an eye on the feed for results summaries.

In terms of movers – GBP consumer-led names rallied – given the economic outlook I think this is more a factor of them being higher beta than anything else.

That said Sunak, did bail them out during Covid and there maybe some expectation he will stand them in the cost of living crisis too.

Leaders and Laggers

Investment Grade

Yesterday was a strong day in Investment Grade given the global move in rates.

In spread terms, the EUR, GBP and USD Investment Grade indices moved +1bp, +1bp and -3bps respectively.

GBP Investment Grade reported its second 2%+ total return day in as many weeks, making it the best-performing asset class aside from rates on the day.

Primary was back in full swing with €2.5bn of issuance from Bouygues (A3/A-) and €400m from Suedzucker (Baa3).

The jumbo dual deal from Bouygues priced 20-25bps inside guidance and books were 2-3x covered. Respectable statistics but nothing that shouts demand is overwhelming.

Still, given the ongoing rally more new issuance is likely to be forthcoming and investors are happy o put their cash to work.

---

Rates

Yesterday’s outsized move in Gilts saw the longer duration tighten most along the curve. This morning the rally in rates looks to be continuing as markets lap up the “slowing pace of hikes” meme.

With the ECB on Thursday, there may be the usual meeting of expectations and reality but for the time being, yields appear to be heading lower.

The 10yr Treasury, Gilt and Bund Yield 418bps, 362bps and 226bps respectively.

---

Equities

Equities were green across the board yesterday supported by the swift resolution of the UK leadership contest and that the FED was going to discuss the pace of hikes at their next meeting.

Equities look to be up between +50 to +70bps in Europe on the open and the FTSE is flat to small down.

Remember, the pain trade given positioning and sentiment is higher and so the rally could gather steam.

Ultimately higher equities and lower yields all point to looser financial conditions and this is definitely not what Central Banks want.

---

Today’s Events

Eco Data

We have German IFO, US consumer confidence and the Richmond Fed.

Today’s Reporting

Boyd Gaming

Crown Holding

Cedacri

Centene

Mattel

NCR

Petra Diamonds

Sensata

Very Group

What Has Caught Our Eye

Meyrick Chapman on Quantitative Tightening and Fewer Dollars

This article from FT’s Alphaville looks at the potential impact of QT on non-domestic dollar borrowers, now that J Powell is bringing the USD home.

Well worth the read – especially with things heating up between the US and China.

“If the news is not all bad for Americans, the same cannot be said for foreign dollar balances. Reduced financial liquidity hurts financial assets. And as loans dampen the effect of monetary tightening on inflation, further asymmetric impact on financial assets can be expected, because more rate rises are needed…It’ll be a mess.”

Meyrick Chapman, FT Alphaville

Bloomberg: “Last Pillar of Credit Is ‘Flashing Red,’ Janus Henderson Warns”

Bloomberg’s Tasos Vasos reports that Janus Henderson has now downgraded its earnings and cash flow outlook to red from amber in Q3.

Janus Henderson uses a traffic light system to indicate the expected outlook for corporate bonds. The 2 other measures, access to capital and debt load, were already red.

This ties in with what we have been flagging in terms of the expected pressure on spreads driven by earnings.

On the upside, Janus is quoted as expecting the default cycle to be shallow and that dispersion will create opportunities across the asset class.

“What started as a liquidity-induced downturn for credit is likely to become a fundamental downturn as credit quality is impacted by central banks’ relentless pursuit of combating inflation,” Janus Henderson said in a report. “Positioning portfolios for recession, heightened volatility and a deterioration in credit quality is prudent.”

Janus Henderson via Bloomberg

Performance

High Yield

Investment Grade

Rates

Equities

Measure (bps)	Fri 14th Oct	Mon 17th Oct	Change	Spread 5-Year Average	Current Spread Z Score
UK CDS – German CDS Spread	15	14	-1	5	5.67
10 Yr UK Gilt – 10 Yr Bund Spread	199	170	-29	99	1.21
10 Yr UK Gilt – 10 Yr BTP Spread	-45	-68	-23	-60	-0.4