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The quarterly outlook for credits: remortgaging shareholder equity

05-07-2016 | Outlook | Sander Bus, Victor Verberk American companies are levering up and central banks are providing ever cheaper money. With increasing debt, markets are becoming more vulnerable to volatility. We pursue a guerrilla strategy, adopting a neutral starting point and taking tactical positions where value pops up due to excessive fear. We start with a higher beta driven by the Brexit spread premium.

Speed read:
  • Corporate America is raising ever more debt to repurchase shares
  • Central banks are trying to extend the recovery with ever cheaper money
  • The main negative short-term technical is the Brexit aftermath
The US economic cycle is probably in its last inning. Corporate America is focused on raising debt to repurchase shares and US corporate balance sheets are rapidly deteriorating as a result. In Asia and Europe the jury is still out on whether we follow the Japan route of secular stagnation or the US route of levering up once more.

Central banks are trying to lengthen the recovery with ever cheaper money. The European Central Bank, for one, is putting a technical floor under the European credit market with EUR 5-10 billion monthly purchases. Trying to stimulate corporate animal spirits for the moment primarily leads to financial engineering in the form of share repurchases.

Value can primarily be found in pockets of the market like Latin American or UK banks. The market however is dominated by technicals. We are all in a deadly dance with the central banks. With ever increasing debt levels, markets are becoming more vulnerable to asset price volatility. The game central banks are playing is a very risky one, and investors have no choice but to join. We prefer being structurally more neutral in beta terms, with tactical positions taking advantage of misallocations in the market due to elevated volatility.

In the short run, the main negative technical is the Brexit vote. It will encourage anti-European sentiment throughout the continent.

What does Brexit mean?

In recent months the risk of a Brexit has been well flagged. Still the actual vote came as a big surprise to markets. What does it mean?

Most economists agree that this does not bode well for the UK and European economies. It is likely that investments and capital flows into the UK (on which it depends given its big current account deficit) will get hurt. As a result we saw a weakening of GBP which by itself could provide some relief.

There are still many unknowns around the actual exit procedure. Most likely the UK will soon start this procedure. About two years later it will be effective. The negotiations for new trade agreements will probably be a tough process. Both parties have an economic incentive to come up with something productive but at the same time European politicians also have an incentive to be very tough, in order to scare off anti-European movements in other countries. This will give nasty headlines for a while. At the same time it might bring the ‘remainers’ closer to each other.

In general, financial markets shrug off big events like this after a few months. Remember the political turmoil around the Crimea or many ‘key’ elections in Europe in the last years. After a while market attention simply shifts to another topic. This time however, we are not so sure. This vote might just be the beginning of much more political turmoil and lead to uncertainty about the future of the European Union. That needs to be priced accordingly.

If anything positive can be said about Brexit it is that the uncertainty might reinforce the conservative attitude in balance sheet management we have seen in European companies. On top of that, these events have also increased chances that monetary support will only get stronger. Both the Bank of England and the European Central Bank will not hesitate to take action when needed.

Overweight in UK financials

In our credit portfolios that allow for it, we have implemented an overweight position in (UK) financials. After the weak performance at the start of 2016, and the weak performance of the negative deposit rates announced in 2015, especially UK financials have never really recovered. UK banks trade 150/200 bp wide to comparable European banks in lower tier II (plain vanilla subordinated bonds) and AT1 bonds carry a yield of  up to 9-10%. We consider that a sufficient compensation to justify an overweight position, despite recent underperformance due to the events discussed.

In the non-financials part of the market, including plain vanilla senior high yield or investment grade corporate hybrids, events have not really dented confidence that much yet.

We do not want to underestimate recent events. It reinforces the tension between weakening fundamentals and political risks on the one hand and central bank support on the other hand. At the same time, the alternative often is zero or negative yield….
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