Big Downside Risks
By Roubini EconoTeam
- Our macro base case remains fairly benign: Improving growth across developed markets, stabilization in emerging markets (a temporary phenomenon in China’s case) and continued monetary easing (with a less-supportive Fed).
- However, we assess the probability of a global downturn at an elevated 30%, and that scenario informs our “fair value” for spreads more than our base case alone.
- We continue to be cautious on investment-grade credit, preferring U.S. over eurozone investment-grade credit on the basis of relative value.
- As energy-related earnings uncertainty has peaked, high-yield spreads appear fair and we remain neutral for now.
- Forecast changes: We have less conviction that the spread between eurozone and U.S. investment grade will widen, as the European Central Bank’s continued monetary easing could provide relief even to problematic credit positions.
- Risks to view: An emerging-market financial crisis and/or China hard landing could lead to contagion; policy makers would surely react, but a surge in defaults and bankruptcies would drive high-yield spreads into the 900-to-1,200-bp range (as is typical when default rates of 8-10% are anticipated), while investment-grade spreads of 200 bps would price in deterioration as well as the odds of restructuring. On the upside, more accommodative monetary policy could further stretch the hunt for yield. Indeed, the risk to our preference for U.S. investment grade over EZ investment grade is that an enlarged or more effective European Central Bank quantitative easing program manages to rekindle fund managers’ hunger for anything with a positive return, driving corporate bond spreads excessively tight.
Commodity-market dynamics and the divergence of central bank policies will continue to influence the credit market in 2016. Falling energy and metals prices have taken a toll on related sectors across the credit spectrum, with defaults and distressed exchanges beginning to gather pace as prices recover only modestly; we expect 10-20% of oil companies in the high-yield space (exploration and production as well as services) to ultimately default—an outcome in line with current spreads (near 1,000 bps).
Quality to Remain a Winner in 2016
The Fed’s rate-hiking cycle has also set the stage for quality to outperform; this was the case in the recent rally, with triple-C junk unable to recover much of its losses. However, higher rates should help financials, and the TLAC draft rules for banks seem less harsh as well, though the new rules may involve bail-ins for senior bonds. This makes default more likely, but also increases conditional recovery value; other buffers (higher capital requirements) may be put in place to reduce the likelihood of default, however.
That said, there is still uncertainty about the types of issuance that will be needed (for example, co-cos), the market’s appetite for this loss-absorbing capital, the ratings treatment of the paper, and whether it will be included in various indices and benchmarks or become “orphaned.”
U.S. Investment Grade vs. EZ Investment Grade
We continue to be cautious on the overall investment-grade complex, largely as a result of a pick-up in late-cycle corporate activities (increased issuance for buybacks, M&A), a saturated loans market, ongoing commodity “adjustments,” the strong dollar and the less supportive monetary environment.
We remain negative on U.S. investment grade, which is in a worse spot in the business cycle, but the value cushion will enable relative outperformance versus very tight European investment-grade spreads. The tights of early 2015, when a frenzy of yield-seeking pushed euro investment grade to 40 bps, have partly unwound.
Depending on maturity, current spreads of around 70 bps swap into a dollar-equivalent of about 100 bps due to a negative dollar-euro cross-currency basis, which appears to be compressed versus a U.S. investment-grade spread of 150. Historically dollar and euro spreads have been highly correlated, with energy-sector turmoil pulling the former’s spreads higher since mid-2014