08 Février 2016

As market participants came into the office in the first days of 2016, the secret hope for most of them was to go and ride the proverbial New Year rally and get some respite from a poor H2 2015. Alas, January turned out to be one of the worst starts of the year for all risk assets across the globe. European credit was no exception and investors are left wondering whether 2016 will be the year when the post-GFC credit cycle turned negative and credit losses started to materialize. We think that there is now a more-than-50% probability to see European credit fundamentals deteriorate and credit assets deliver negative returns in 2016. Not only do we see rising risks from every angle we look at the world, but, more importantly, we believe that European credit markets are today more vulnerable to such risks than at any time since 2009.

Vulnerable to weaker credit fundamentals

For several months, we have commented on the various risks arising around European credit markets: economic, financial and political crises in many large EM countries; slowing growth, asset bubbles and uncertain policy response in China; price collapse and volatility in global commodity markets. As the market started to come to terms with some of those risks, it now has to face some new concerns that may trigger a negative chain reaction for credit fundamentals in Europe. First, the UK referendum on EU membership – and the associated Brexit risk – is increasingly likely to bring uncertainty, risk aversion and instability this year. Then, the lackluster growth prospects coming from the DM is raising fears that the global economy might be closer to recession than what has been factored in by the market. Last, the recent tightening in financial conditions – incepted initially in EM, energy and commodity capital markets – is now spreading to the US and Europe. The longer such turmoil lasts, the more likely it will create second-round effects on economic growth and on the ability of corporate Europe to get access to capital markets.

Such a scenario would, in turn, drive a deterioration in European credit fundamentals across all segments of our market, at a time when the balance sheet of many borrowers has not fully healed from the excesses of the previous credit crisis. Specifically, European HY could be hit as a result of rising leverage and of the worsening credit quality in recent issuer vintages. For European banks, the outlook is also uncertain as the sector’s stronger fundamentals generated by the post-GFC regulation – high solvency, smaller balance sheets, improved asset quality, stronger liquidity, etc. – could in the end offer little protection to its creditors in a world of “bail-in able” instruments.


Vulnerable to widespread risk aversion and the lack of market liquidity

As contagion is now spreading from EM/energy/commodity credit to the rest of credit markets, we think that rising risk aversion places European credit markets on the verge of a negative spiral, which could see them gapping much wider/lower. One could object that central banks will come to the rescue should such a scenario start to play out. On our side, we have little doubt that the ECB will enhance its program of non-conventional measures in the next few months and could even do more to comply with its price stability mandate. However, while highly effective to maintain a strong demand for EZ government bonds at historically low yields, we are increasingly skeptic that the ECB non-conventional measures would restore significant risk appetite in private credit when investors are now increasingly focused on the potential for credit losses in their portfolios.

With a “Draghi put” more effective for public-finance and super-senior credit – e.g. govies, local authorities, covered bonds, etc. – than for true private credit – e.g. IG, HY, loans, etc. – the growing lack of liquidity in fixed income markets creates another layer of vulnerability for European credit markets. It is worth noting that the credit market refrost experienced since the beginning of H2 2015 has not led to major redemptions out of the asset class. However, in a market where confidence seems broken, investor risk aversion is at a high point and the outlook for credit fundamentals has worsened, the lack of market liquidity will likely magnify the above-mentioned risks. The drastic cuts in banks’ balance sheets available for market making activities combined with the huge growth in the outstanding volumes of tradable instruments create a highly unstable environment in times of severe volatility, in our view. When every day of market stability is seen by most investors as an opportunity to reduce risk in their portfolios, the price action usually becomes one-directional – i.e. wider/lower.

Protect capital and keep some dry powder

In the face of that many risks and with valuations only pricing in average default rates, we are of the view that risks are skewed to the downside. As a result, we have cut our exposure to HY further by unwinding certain long positions, concentrating the remaining long positions mostly on relatively short-dated instruments, catalyst-driven stories or deeply-discounted bonds, and adding to our hedges. In IG, we continue to add to our book of single-name shorts in sectors which do not price the risk of a broader credit crunch. In financials, we are also positioning the book for greater resilience in the event of a widespread credit crisis and against some more sector-specific risks, such as Brexit, the resolution of the NPL issue in the Italian banking sector, the lack of clarity around coupon payment language in the AT1 market, or some idiosyncratic stories – think of the recent negative headlines around DB and CS.

Our readers may wonder why we should keep some dry powder in such a gloomy environment. It is precisely because the market may well turn even gloomier and more negative, in which case the repricing of European HY and subordinated financials will provide again attractive risk-adjusted idiosyncratic long stories. If we are already in a credit crisis, the end of it is not in sight but the repricing process already started more than 6 months ago. That means that the selloff would likely continue or accelerate in the foreseeable future, but that it would subsequently abate. Patience is key at the moment but experienced credit investors also know that it’s during periods like this one that one set sights on tomorrow’s winning trades.


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