The Rearview Mirror: May 2018


How should we read the recent market price action? Definitely the yield of the benchmark 10-year US Government bond that tested the psychological level of 3% could be considered a sort of game changer. Let’s be clear from the beginning. We do not believe that discounting the stream of future corporate cash flows at 20/25 bps higher than a month ago could significantly derail their market valuation.  It’s the spread between the short-end of the curve and its long-end that should be watched seriously. Less than 50bps on the government curve and even less on the interest rate swap curve, potentially is showing a conflict, especially if the flattening goes on and collapses in a inverted yield curve. Usually an inversion is synonym of an upcoming recession. Perhaps this is not the current base scenario.

In fact, even if macro data in US and Europe, are losing momentum, the growth pace is still solid: the global economy can still count on the upcoming US fiscal stimulus, the Central Banks are in some way in a cautious mode, the easygoing role of Dollar that is continuing to stimulate the US esports and the health of some emerging countries and finally the behaviour of several commodities emphasising a strong demand just to enumerate some positive factors. Hence, what is wrong if we are experiencing such an endless flattening combined with a loss of momentum for the equity rally. Well, so far the spectacular earnings season was nearly fully priced in. It is like we are short of a positive and unexpected trigger that could galvanise the risk-on mood. Also, the more serene tone of the international community appears not strong enough to convince investors to insist on the “buy everything” behaviour.

Maybe investors are starting to consider that the end of asset purchases by the ECB and the BOJ is not so far: later this year or early next, a source of buyer of last resort, could slowly evaporate. Yes, there is still a combination of pension funds and long-only passive instruments, that could provide some liquidity to the market, but recent sell-off and higher volatility should be taken into consideration. Especially when we are referring about a specific asset class like corporates bonds, where a perfect combination of distortion in market prices is already existing. First of all, the complacency of this asset class, despite latest equity correction, is not an evidence of a healthy environment. When a global financial player decides to deleverage its exposure, it is easier to act by cutting their equity or government bonds assets. Moreover, credit spreads continue to narrow, thanks to a sector rotation that for instance allowed energy names to outperform. Yet, the entire asset class is even more vulnerable. There is less space for a credit compression, especially when companies are faced with higher yields and investors are not paid enough for a liquidity premium.Dollaro

At the moment I am convinced that the focus is more on liquidity. An US investor is well remunerated for its cash positions. The 2yr US government yield is now at 2.5% and also shorter maturities have started to take into account at least 2 hikes more during the course of 2018. This, together with a lack of visibility, is discouraging investors to keep on their trades that outperformed so far. It will not be an easy task to find a buyer when a majority of players want to leave the same asset class. And as we have seen during last equity correction, also the government bond experienced a positive correlation. The question is how long an investor in HY can wait before exiting from the asset class. We can find a good answer in the appetite for the new issues. A reliable example is the interest that market participants expressed into the rather unclear cash flows generated by the platform WeWork that was able to collect orders of $2.5b-$3b. It is a clear signal that the amount of money to be invested is still conspicuous. By contrast the fact that on the secondary market most of latest new issues, included the workspace platform, are not performing well can reveal a warning signal.

Additionally, an investor should be compensated for a liquidity premium in line with the particularity of the asset class. For example, current credit spreads offered by corporates and financials, are not providing the investor with the correct yield in order to protect himself from a widening of spreads or for the temporary illiquidity of the instrument. In a normal environment, corporate bonds are considered to be very liquid, but with the marginal role played by investment banks in assuming risk, the liquidity exists only if a seller meets the interest of a buyer. Back again, I would avoid crowed trades, specifically when the exit strategy is not the easiest one.

 Christian Zorico: LinkedIn Profile

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