While the Stock Market is Partying …
There are seemingly always “good reasons” why troubles in a sector of the credit markets are supposed to be ignored – or so people are telling us, every single time. Readers may recall how the developing problems in the sub-prime sector of the mortgage credit market were greeted by officials and countless market observers in the beginning in 2007.
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At first it was assumed that the most highly rated tranches of complex structured products would be immune, as the riskier equity tranches would serve as a sufficient buffer for credit losses. When that turned out to be wishful thinking, it was argued that the problem would remain “well contained” anyway. After all, sub-prime only represented a small part of the overall mortgage credit market. It could not possibly affect the entire market. This is precisely the attitude in evidence with respect to corporate debt at the moment.
The argument as far as we’re aware goes something like this: there are only problems with high yield debt in the energy and commodity sectors. This cannot possibly affect the entire corporate credit market. We should perhaps point out that in spite of this sectoral concentration, problems have recently begun to emerge in other industries as well (a list of recent victims can be found at Wolfstreet).
The argument also ignores the interconnectedness of the credit markets. Once investors begin to lose sufficiently large amounts of money in one sector, the more exposed ones among them (i.e., those using leverage, a practice that gains in popularity the lower yields go, as otherwise no decent returns can be achieved), will start selling what they can, regardless of its relative merits. This will in turn eventually make refinancing conditions more difficult for all sorts of industries.
It also overlooks that energy and commodities-related debt is simply huge and the losses are really beginning to pile up by now. The junk bond market has grown by leaps and bounds during the echo bubble, so a lot of money has become trapped in it. Many low-rated borrowers need to continually refinance their debt, otherwise they will simply fold. Once liquidity for refinancing dries up – and this is what growing losses in a big market segment will inexorably lead to – it will be game over.
Merrill Lynch high yield Master Index II effective yield (black line) and the yield on the CCC and lower segment (lowest rated credit/ red line). The worst rated bonds have been in relentless free-fall since the 2014 low in yields, with a move from 7.94% at the low to 14.71% today. Note bene, this has happened with administered interest rates stuck at zero over the entire time period! The better rated junk yielded 5.16% at the 2014 low, and yields 8% as of today, adding more that 280 basis points in bad juju since then. These yields are comparable to the woeful situation in 2011, when the euro area debt crisis was nearing its peak – click to enlarge.
It has turned out in hindsight that when we wrote in detail about the unsound boom in corporate debt last year, the price bubble in junk bonds had actually peaked a mere five trading days earlier. Nevertheless, debt issuance in both junk bonds and leveraged loans subsequently continued at a brisk pace for more than a year or so – this has only begun to change in recent months. The reason is that the losses are now indeed becoming rather concerning. In a recent note on the spike in default rates in the commodities space, Fitch remarks by way of summary:
Energy Default Rate Heads to 6%; Arch Filing Would Push Metals/Mining Over 14%. November already has added five defaults from the energy and metals/mining sectors.
The energy trailing 12-month (TTM) default rate finished October at 5.3%, the highest point since a 9.7% peak in 1999, while the exploration & production subgroup TTM rate hit 9%.
The metals/mining October TTM rate stands at 9.5% while the coal subsector jumped to 27%.
A potential filing for Arch Coal Inc. would propel the metals/mining TTM rate above 14% and the coal subsector to 40%.
The October TTM rate not including energy, metals/mining and Caesars Entertainment Operating Co. is 0.7%.
Energy and metals/mining experienced no new high yield bond issuance in October, the first time this happened since August 2011.
As you can see from the above, excluding all the bad stuff, things still look fine, but the bad stuff looks really bad. Someone is eating big losses, that much is certain. The fact that the rest of the corporate debt universe hasn’t been affected yet is where the “it’s well contained” idea comes from, but the only relevant question is really whether it will remain contained. The data say it won’t. The corporate credit bubble has become too large, while the cash flows supporting it are beginning to crater.
A chart recently published by Societe Generale’s research department: until 2012, the massive growth in corporate net debt was still supported by commensurate growth in EBITDA (earnings before interest, taxes, depreciation and amortization). In the meantime a sizable gap has opened between the two – debt has continued to grow, but the income that supports it has begun to head in the opposite direction – click to enlarge.
Defaults Poised to Surge
Not surprisingly, the credit rating agencies are beginning to increasingly express concern over these developments. A recent report by Moody’s notes under the heading “The Credit Cycle Wanes”:
“The US corporate credit cycle now fades. Thus far, the US high-yield credit rating revisions of 2015’s final quarter hint of the fewest upgrades relative to downgrades since 2009’s recessionary second quarter.
To date, the US high-yield credit rating changes of 2015’s fourth quarter show 57 downgrades far exceeding 18 upgrades. In addition, the accompanying revisions of investment-grade ratings include 11 downgrades and only one upgrade.
The final quarter of 2015 is shaping up to be the second straight quarter of substantially fewer high-yield rating upgrades relative to downgrades. A convincing negative trend may be emerging.
As long as high-yield downgrades well outnumber upgrades, any extended narrowing by the high-yield bond spread is suspect. For example, first-half 2007’s narrowing by the high-yield spread amid a distinctive upturn by net high-yield downgrades would prove to be a big mistake.”
In short, if there should be a short term rally in junk, use it to get the hell out of Dodge while you still can.
Accordingly, expected default rates are now increasing as well, and have reached levels that were last seen in 2009. As Moody’s notes in this context:
“The average expected default frequency (EDF) metric of US/Canadian non-investment-grade issuer is a forward looking indicator of the default rate. Recently, the high-yield EDF metric approximated 5.6%, which topped each of its previous monthly readings going back to the 6.4% of August 2009.
Given the surge in the number of downgrades, plunging upgrades, and the likelihood of significantly more defaults, the recent composite high-yield bond spread of 595 bp is unlikely to soon approach its 424 bp average of the two-years-ended June 2015. If anything, Q3-2015’s decidedly sub-par showings by business sales and operating profits warn of wider, instead of thinner, spreads.”
This confirms something we warned about when the market peaked in the summer of 2014. As we wrote at the time under the heading “The Expected Default Rates Trap”:
“[W]e want to briefly comment on the one data point that probably contributes more than any other to investor complacency: the expected 12 month default rate. All credit agencies put this expected rate at a new low for the move in 2014, not unreasonably arguing that because companies have issued so much debt, they are currently flush with cash and can postpone their refinancing plans if necessary.[…]
Only in the 2001-2003 post technology bubble recession was a higher proportion of HY debt employed for refinancing purposes. Obviously, with demand for HY debt extremely high, even bad credits have little problem refinancing their debt. In other words, we are observing a feedback loop here: on the one hand, investors are emboldened by low default rates to keep refinancing HY borrowers, on the other hand it is precisely because they keep refinancing them that default rates remain so low.
As long as enough new money is provided the show can go on, but obviously, this is highly dependent on investor confidence. The question is therefore, when is investor confidence at its most vulnerable? Ironically, this is precisely when it is at its highest. When spreads and volatility are extremely low, they indicate a high point in confidence. This implies however that confidence can no longer improve further. Once things are “as good as they ever get”, there is just one way left for them to go: they can only get worse.”
Well, they sure have gotten worse. In the time period 2009 to 2013, between 53% and 64% of all high yield debt issuance proceeds globally were used for refinancing purposes. It doesn’t take a big leap of the imagination to see that problems could arise if investors should begin to balk. Indeed, the recent surge in defaults and default expectations has been marked by issuance in the most vulnerable segments of the corporate bond market grinding to a halt (see the Fitch comment above: HY issuance by energy and metals and mining companies in October stood at zero – the dip buyers are finally taking a break).
Moody’s notes that banks are pulling back concurrently and are busy tightening their lending standards with respect to commercial and industrial (C&I) borrowers. While the agency is uncertain of the precise cause-effect vector at work, this is how credit booms usually end: lenders begin to become nervous about their exposure and stop extending credit to dubious borrowers. Tightening lending standards tend to lead HY spreads as the chart below illustrates:
What is so remarkable about all this is that it has happened before the Federal Reserve has hiked rates even once from their current zero to 25 bp corridor (in practice, the effective FF rate has been oscillating between 7 and 14 basis points).
This is highly unusual and indicates that the end of QE3 must indeed, as we have always argued, be regarded as a significant tightening of monetary policy.
Thus the often heard refrain that the “taper” did not mean a tightening of policy was and remains misguided. Once an economy is hooked on an ever accelerating expansion of money and credit, any slowdown of said expansion will eventually trip the boom up. We also have confirmation of a tightening monetary backdrop from the narrow money supply aggregate M1, the annualized growth rate of which has been immersed in a relentless downtrend since peaking at nearly 25% in 2011. We expect that this trend will turn out to be a a leading indicator for the recently stagnant (but still high at around 8.3% y/y) growth rate in the broad true money supply TMS-2.
Stock Market Fantasies
The stock market is traditionally the last market to get the memo – this is the case at present as well. As mentioned above, there is no shortage of rationalizations when segments of the credit markets come under pressure, and there is no shortage of rationalizations with respect to the stock market’s increasingly deteriorating internals either. This time it’s different!
Who cares if only a handful of big cap stocks is holding up the indexes? They deserve to trade at triple digit P/Es! Nothing can go wrong! Anyone who has observed the markets for a bit longer than today’s 20-something hotshot traders has heard it all before – several times. The sharp deterioration in credit-land is however one of the starkest warnings for risk assets yet.
Given that the Fed – focused as it is on lagging economic indicators – seems bent on hiking its administered rates shortly, one wonders how an actual rate hike cycle is going to affect the situation. Our hunch is that it won’t make things easier for assorted credit and liquidity junkies. On the other hand, one can probably be fairly certain that it won’t actually become a “cycle”. More likely it will end up a version of the BoJ’s repeated attempts over the years to hike rates, i.e., it will ultimately go nowhere.
In the meantime, the ratio of junk bond prices to equity prices has trended relentlessly downward, something that can be observed with unwavering regularity ahead of major market peaks. After all, the “it’s different this time” notion is holding sway every time – and it has a tendency to sound increasingly delusional the longer the stock market remains superficially strong.
The price of junk bond ETF JNK (unadjusted) and the JNK-SPX ratio – stock market participants once again assume that credit market deterioration cannot harm them. This costly error is seemingly made every time – click to enlarge.
This isn’t going to end well, if history is any guide. Meanwhile, the foundation of the economy continues to look rotten (the newest round of Fed surveys has begun with another bomb and other manufacturing-related data continue to disappoint as well). It is no consolation that the service sector’s performance is still holding up better. Fo instance, a lot of spending related to health care has increased sharply. This is simply consumption, the price of which has moreover been distorted by government intervention. These artificially inflated activities aren’t going to create any wealth.
In addition, the misguided view that “manufacturing is just not important to the economy”, continues to hold sway as well. This is based on the misleading representation of actual economic activity in GDP. Gross output is telling the real story as we often point out. It should also be noted that every boom ends with capital goods and other higher stage industries affected first and the most. This is simply the nature of the credit-driven boom-bust cycle. Ignore the signs at your peril.
Charts by: StockCharts, Société Générale, Moody’s, St. Louis Federal Reserve Research