What’s Behind The Eerie Calm In Corporate Credit
By Vishwanath Tirupattur, global head of Quantitative Research at Morgan Stanley
Over the past few weeks, risk markets have been buffeted by volatility from a wide array of sources. It was around a month ago that the regulatory reset in China and near-term funding pressures on select property developers roiled global markets, as investors fretted over the systemic implications for global growth. A mixed US jobs report along with sharply higher commodity prices intensified the debate around stagflation. Rhetoric from multiple central banks has been increasingly hawkish. The combination of these concerns has resulted in substantial market gyrations. Relative to a month ago, the S&P 500 Index declined by about 4% before recovering to up 6%. The shape of the Treasury yield curve has twisted and turned. The benchmark 10-year Treasury interest rate went from around 1.30% to around 1.70%, and market pricing of the timing of a Fed rate hike has come in sharply.
Amid these substantial moves, corporate credit markets on both sides of the Atlantic have largely stayed calm. Credit spreads in investment grade, high yield and leveraged loans across the US and Europe have hovered near 52-week tights, with surprisingly limited volatility.
Credit market beta relative to equity markets remains very low. Market access for companies across the credit spectrum has remained robust, as indicated by strong issuance trends, running at or ahead of the pace a year ago. What explains this stark difference between credit and other markets? The answer boils down to meaningfully improved credit fundamentals and elevated balance sheet liquidity, leading to a decidedly benign outlook for defaults over the next 12 months, if not longer.
Our credit strategists, Srikanth Sankaran and Vishwas Patkar, have highlighted that the balance sheet damage from COVID has been reversed. At the end of 2Q, gross leverage in US investment grade credit had declined sharply to 2.4x, back to pre-COVID levels. Net leverage is now below pre-COVID levels, while interest coverage has risen sharply to a seven-year high.
The trends in the high yield sector are even more impressive and the improvement broad-based, driven not just by the rebound in earnings but also negative debt growth. At 3.87x, the median leverage of high yield companies in our coverage universe for 2Q21 is down 0.5x Q/Q and 0.89x Y/Y. After four consecutive quarters of declines from the 2Q20 peak, median leverage now sits below the pre-COVID trough. That 71% of the issuers are reporting lower gross leverage Q/Q reflects the broad-based improvement.
Encouragingly, the size of tail cohorts has also begun to normalize – the share of issuers reporting 6x+ leverage is down 7 percentage points on the quarter. On the median measure, debt balances were 3.9% lower Y/Y while LTM EBITDA was 17.5% higher. Median interest coverage increased in the quarter to 4.68x (+0.52x Q/Q), with a solid 82% of issuers posting improved coverage. Cash-to-debt ratios remained close to record highs at 15.6%. Even in LBO land, while 2021 has been a bumper year for acquisition activity, with transaction multiples and debt multiples at record highs – usually a source of concern for leveraged loan and high yield bond investors – unprecedented equity cushions have resulted in a better alignment of sponsor and lender interests, helping to alleviate concerns.
These improvements in credit fundamentals explain the low-beta behavior of credit versus equity markets. Earnings and margin concerns matter for credit investors, too, but the intensity and breadth of balance sheet repair matter more. Furthermore, given the sharp rally in stocks, equity cushions in capital structures have increased and leverage as measured by debt-to-EV has declined.
What are the implications for investors? A lot, of course, is in the price. With credit spreads near the tight end of the spectrum, we are more likely to see them widen than tighten.
Indeed, the base case expectation of our credit strategists is for modestly wider spreads. However, the strength in credit fundamentals suggests that the outlook for defaults is benign and likely below long-term average realized default levels. Thus, we prefer taking default risk to spread risk here, leading us to favor high yield over investment grade and, within high yield, loans over bonds. For the more sophisticated investor seeking double-digit returns, the best expression of this view would be through equity tranches of collateralized loan obligations (CLO). Structural leverage as opposed to repo leverage, cash flows that are front end-loaded, multiple embedded refinancing options, all combined with the expectations of benign defaults, make CLO equity tranches a particularly interesting opportunity.
Back into positive territory
Stock markets are off to a positive start to the week in Europe and the US, in keeping with the price action we’ve seen over the last week since the…
Stock markets are off to a positive start to the week in Europe and the US, in keeping with the price action we’ve seen over the last week since the new variant discovery.
Reports of the Omicron symptoms being less severe are boosting risk appetite but it’s too soon to get carried away. For one, we’ve seen this repeatedly since the initial news broke a little over a week ago. Markets have been very headline-driven and this is just the latest rally on the back of some positive reports.
While this may be the first in a slew of positive data around the new variant, it could also be the anomaly and what follows could explain why world leaders and various agencies have been so anxious. Let’s hope for the former but I expect extreme caution to remain until the data gives us cause for more optimism.
Weeks like this, the economic data would always play second fiddle but as it turns out, it’s looking a little thin on that front and central banks are in the same position as the rest of us. So the rest of the week will remain very Omicron headline-driven which will likely mean plenty more volatility.
By then, we may know a lot more which means the conversation can move on to the monetary response. Unfortunately, that comes too late for the RBA and BoC tomorrow and Wednesday, respectively, and perhaps just in time for the Fed, ECB, and BoE next week. If the news isn’t good on the variant then central banks are going to find themselves in an awful position, which could rock the boat somewhat.
Bitcoin partly recovers after crash
Bitcoin has had an eventful few days, having been pummelled on Saturday before recouping much of those losses. Whatever the cause of the flash crash, it hasn’t managed to fully reverse the losses and remains below USD 50,000. That could leave it vulnerable in the near term, especially with it struggling to track other risk instruments higher on the day. Bad news on Omicron could really put it under pressure.
For a look at all of today’s economic events, check out our economic calendar: www.marketpulse.com/economic-events/
Business As Usual Despite Omicron
Investors hoping that Friday’s release of the November…
“Business As Usual” Despite Omicron?
By Jane Foley, head of FX strategy at Rabobank
Investors hoping that Friday’s release of the November US labor market would be a simple tick-box exercise for the Fed’s move towards policy normalisation were likely disappointed. The headline non-farm payrolls report at 210K was only about half what the market had expected it to be, though the shock of this number was lessened by talk of a potentially unreliable seasonal adjustment in addition to a strong set of data from the household survey. The latter showed a sharp drop in the unemployment rate to just 4.2% in November. For many this will have been sufficient for the Fed to continue preparing to announce a hastening in the pace of tapering of its bond buying program at the December 14/15 FOMC meeting. After a volatile fortnight on the back of fears of a more hawkish Fed, the Nasdaq closed down 1.92% on Friday. While Asian stocks this morning mostly followed US stocks lower, futures are showing signs of resilience.
Despite the confusion surrounding the economic implications from the Omicron variant, Fed Chair Powell and other FOMC members had suggested a ‘business as usual’ approach to policy last week by suggesting that a hastening in the pace of QE tapering very much remained on the cards. The fact that the market consensus for this week’s US November CPI inflation release stands at a eye-watering 6.7% y/y will be seen by some as an endorsement of the Fed’s hawkish tone.
That said, the IMF has warned of growth risks stemming from Omicron and other central banks seem prepared to take a more cautious approach. The BoE’s Chief hawk Saunders, who voted for a rate hike in November, suggested on Friday that he would like more information on Omicron before deciding how to vote on policy next week. The UK money market has backed away from fully pricing in a BoE rate hike for December, though a February move is still on the cards. Both the BoC and the RBA are due to meet this week and steady policy is expected from both. Omicron is likely to provide the RBA with further reason to extend its already dovish position. That said, the strong rise in Canadian employment in November is feeding speculation that the BoC could bring forward rate hikes, with April being touted by commentators as a possible start date for policy tightening.
There have been various headlines in recent days in a slew of countries about additional restrictions being put in place in an effort to slow the transmission of Covid. Over the weekend police in Belgian used water cannon and tear-gas to disperse violent protests against fresh restrictions. Germany last week announced social curbs on the unvaccinated while Greece introduced fines on the over-60s who refuse to be jabbed.
As evidenced by the protests, none of this sits comfortably in liberal democracies with some premiers, such as UK PM Johnson, likely very nervous of a backlash from any further fresh restriction. Omicron has now been detected in seventeen EU countries and US data suggest that Omicron has spread to around one–third of US states, though Delta remains the dominant variant. Encouraging there have been several press reports indicating that while Omicron may increase the risk of transmission, the symptoms may be milder. This view was endorsed by US infectious disease official Fauci over the weekend who commented that “thus far it does not look like there’s a great degree of severity to it.” That said, S. Africa is preparing its hospitals for more admission, though its low vaccine rollout rate will be a factor.
Bitcoin took a tumble over the weekend as profit-taking picked up momentum. Gold found support on the fall back in longer term bond yields and oil prices picked up some support after Saudi Arabia raised prices for crude sold to Asia and the US. No real progress appears to have been made on reviving the nuclear deal between the US and Iran.
President’s Biden and Putin will speak via video call on Tuesday amid mounting tensions over Ukraine. This follows reports from US Secretary of State that there was evidence that Russia had made plans for a ‘large scale’ attack on Ukraine. It is expected the Biden will reaffirm US support for the sovereignty and territorial integrity of Ukraine. Bloomberg news have reported that over the weekend there was a ‘testy exchange’ between US Secretary of State Blinken and Russian Foreign Minister Lavrov over Ukraine with the former recapping events in 2014 when more than 100 people participating in a peaceful protests were killed.
Evergrande is back in the headlines this morning following a statement from the Chinese property developers on Friday saying that creditors had demanded USD260 million and that it could not guarantee enough funds. Chinese government officials summoned Evergrande’s Chair and the PBoC has stepped up its criticism of the company accusing it of ‘poor management’ and pursing ‘blind expansion’. Reports in Chinese state media that Beijing will cut banks’ reserve requirement ratio ‘in a timely way’ lent a little support to mainland Chinese blue chips overnight
A decidedly weak -6.9% m/m print for October Germany factory orders this morning is a sharp reminder of the headwinds facing the Eurozone’s largest economy. Tomorrow, German ZEW survey data is also expected to soften. Key UK data this week includes monthly GDP data and production numbers for October. In addition to the November CPI inflation data, the US calendar also includes the December Michigan confidence survey. Ahead of next weeks Fed, ECB, BoE and BoJ policy meetings little additional direction can be expected from central bankers leaving more room for investors to seek clues from this week’s BoC and RBA policy meetings.
Toward the Final Transition
A Book Review of Grand Transitions: How the Modern World Was Made, by Vaclav Smil.1
Over the last two decades, Vaclav Smil has produced a series of outstanding…
- A Book Review of Grand Transitions: How the Modern World Was Made, by Vaclav Smil.1
Smil’s most recent book, Grand Transitions, brings together his main concerns and interests. The subject of the book is the popular one of the nature of modernity and the modern world, the ways in which they differ from the greater part of the historic human past, and the process by which the old world of traditional society gave way to the one we now inhabit:, the modern. The work deftly combines two ways of addressing these:, by identifying and quantifying the novel or contrasting features of modernity as compared to the traditional, and by setting out and quantifying the processes that brought these into being. This also makes possible the subject matter of the final part of the book, which is an argument about what the future may hold. Revealingly, this last part is done more in terms of negatives—arguments about what will almost certainly NOT happen rather than extrapolations or forecasts of what WILL happen. The reason for this is the (correct) argument that we can be much more certain about what is impossible or highly unlikely than about what is possible. It would be easy for such an expansive survey to become ill-defined and sprawling but Smil avoids this with because of his clear conceptual framework and the argument that flows from it, something that draws upon his previous work.
The key concept is that of a transition. This is not original to Smil, of course, but is widely employed in discussions of modernity. The way it works is to identify in a major area of human life—such as demography, politics, or economics—the dominant features of the traditional world that we can see persisting across the centuries and variations of geography and culture and compare and contrast them to the persistent and dominant features of the contemporary world. The next step is to identify and describe the way one changed into the other over the last two to three centuries (never more than that), and so to define the nature of the transition from the one to the other. What this makes possible is a quantitative approach that also examines qualitative questions. The issue that is not easily addressed—either in Smil’s work or others like it—is that of causation, of what it was that caused the transitions. Smil’s own approach is resolutely empirical, and he explicitly argues against the use of theoretical models (especially those involving advanced and complex mathematics) and elaborate abstract theory. He takes the view that attempts to identify causes for observable major changes are almost always bound to fail because of methodological challenges but, above all, because of the central role of contingency and randomness in the historical human story. The reason for this is the nature of complex systems (examples being with both human societies and natural ecosystems being examples of that) and the difficulty of directly linking outcomes to preceding states in such a system, along with the notorious problem of high dependence upon random initial conditions and strong path dependency. What one can do—and he does expertly—is to present a careful account of the shifts and processes, as accurately as possible given the limitations of evidence. This modest approach is refreshing and welcome when we contrast it to the elevated claims to insight and knowledge that we find elsewhere.
Smil identifies four key transitions—the ‘”grand transitions”’ of his title. These are: demographic, agriculture and diet, energy, and economic. For many, the most familiar for many is the demographic, the transition from a world of high birth rates and high mortality levels—particularly among children—to one of low birth rates (often below replacement level) and low death rates. The transition involves a time period when for some time the birth rate remains high while the death rate falls with a dramatic rise in population as a result until the birth rate declines. This transition has been completed in many parts of the world but is still in process in others. All the indications are that it will have happened everywhere by the middle part of this century. One aspect of this transition that is now becoming apparent is an ageing of the population, with an unprecedentedly high proportion of the population being elderly. The second—agriculture and diet—is marked by the movement from a world of subsistence where food production was often precarious, to one where a combination of economic integration and technological innovations (such as artificial fertilizers and pesticides) plus innovation in both varieties of crops and farming methods has produced a level of food supply that our ancestors would have seen as abundant. Smil emphasizes how this is not simply a matter of more food of the traditional kind being produced and consumed as there has also been a dramatic transition in diets with a move towards much greater variety and, generally, much higher intakes of fats and refined carbohydrates and meat (as opposed to grain products). This has pled to the novel situation of health problems caused by overeating rather than starvation and malnutrition.
The last two are separate in Smil’s account but reading the relevant chapters reveals that for him economic and energy transitions are so interconnected that it could make sense to see them as a single phenomenon. The economic one is the well-known path in which we have gone from a world where living standards were low for the overwhelming majority and very stable over the long term despite periodic fluctuations to one where they rise steadily. The energy transition is the movement from a world where the primary source of energy is human and animal muscle power—augmented where possible by wind and water—to one where these are enormously added to by energy derived from fossil fuels and, more recently, nuclear and renewable sources. The two transitions are connected because of the way that the great increase in productivity (and, hence, living standards) since the early nineteenth century is clearly in large part connected to the increasing employment of these new sources of energy—notably but not only in the form of electricity.
All this raises several questions. There are four transitions for Smil, but could we also argue that there are others? The obvious candidate is innovation with a transition from a world where innovation was rare, slow to be adopted and diffused, and systematically restrained and discouraged by both overt power and social institutions, to one where it is omnipresent, rapid, and generally lauded (at least officially). This clearly plays a part in all the other transitions. I suspect that the reason why Smil does not add this is because it is much more difficult to measure (given that, for various reasons, patents are for various reasons not a reliable measure and, in any case, only exist for the period since the other transitions were under way). Another question is this: the four transitions are clearly interconnected but might we argue that one is foundational and driving all the rest? The best candidate for that is the energy transition, but even there it is not clear how that can be seen to have caused the demographic one. Smil shows that the evidence does not support the common belief that it is the economic transition that drives the demographic one if anything the opposite is true. Alternatively, and more in line with Smil’s own approach, might we argue that the four transitions are so interdependent that none of them could take place singularly and that all four had to happen together or not at all?. This would emphasizse the degree to which we are dealing with a complex phenomenon that can be measured and described but which resists analysis, much less prediction.
That in turn brings us to the final part of Smil’s work, which summarizes much of his previous writings, and looks at where we are now and what is the likely future of these transitions is. One central point, —which is why he uses the term ‘”transitions”—is that, in his view, it is overwhelmingly unlikely that the processes that have produced these transitions will continue indefinitely or even for much longer. Instead of an open-ended process, what we will have is a movement from one stable state to another, a step change and hence a transition (as opposed to e.g. a ‘”take-off”’). The way this can be put mathematically is that we are not looking at exponential curves in the various indicators but logarithmic ones (S curves). The argument Smil makes—here and elsewhere—is that the transition is almost complete and that therefore we are therefore approaching the top of the logarithmic curve where it rapidly flattens out. For example, this implies for example that we are coming to the end of an era of economic growth and arriving at the steady state predicted by inter alia Adam Smith and John Stuart Mill. Another implication is that population growth will fall dramatically and be succeeded by decline until there is a new steady state, while yet another is that both the impact and rate of innovation will decline. If true, aAll of this has far-reaching implications if true. So much of our political thinking, for example—in all parts of the spectrum—is built around the presumption of continued growth that it will be a radical disruption if this does stop. It will make sense, in that case, to return to the thinking—and maybe even the practice—of thinkers from earlier periods who did not have that foundational presumption, or at least to update them.
One thing Smil argues very forcibly is that we will not see either a continued growth in energy usage or a major switch to renewable energy. He reiterates the argument he has made elsewhere that this is extremely unlikely because of the fundamental problem of energy density. The great advantage of fossil fuels is that they contain large quantities of energy in lightweight and compact form, so they have a high density, which in turn means they can do a lot of work. By contrast, renewable energy sources—particularly solar power and wind power—are diffuse, which means they have much less usable energy. They are fine for producing electricity (allowing for intermittency) but it is difficult to impossible to employ them for things such as transport, or industrial heating (including processes such as steel making and cement production). The problems with all the alternatives suggested are both technical and economic—there is the common problem of technologies that are technically feasible but hopelessly uneconomic. The consequence is that we can look forward to not only a stagnation of energy usage but a significant decline, due to the declining EROEI ratio of existing sources (EROEI = Energy Return Over Energy Invested, the ratio between the amount of energy gained and the energy that has to be expended used to get it). This has very obvious and extensive implications, which most people have not started to consider.
One point that Smil spends a lot of time exploring is the question of whether the final stage of the transitions will be a move to greater “‘dematerialization”’ brought about by the combination of greater wealth and increased difficulties with energy supply. The argument is that the pattern of the economic transition is for increasing productivity in which resources are used ever more intensively to produce ever larger amounts of physical output. As with all processes, this faces diminishing marginal returns and, eventually, what is increasingly produced are not physical products that require inputs of raw material and energy but immaterial ones where the only major input is time. These are not subject to the limits that restrict the continued growth in the production of physical products and services. All of this is very similar to the speculations of J. S. Mill in his consideration of the steady state towards the end of his Political Economy and again raises all kinds of fascinating questions as to the implications for our current economic, social, and political arrangements. Smil himself is too cautious and respectful of the limits of his evidence to come to a firm answer although he clearly thinks that this route of dematerialization of economic life is probable.
This book is a great starting point for anyone interested in exploring finding out about Smil’s work and thought for the first time—even though it is his latest work—because it is in some ways a summation of the main themes and arguments he has explored over the years. It is also a wonderful read for anyone interested in the question of what exactly the difference is between the traditional world and the modern world and how we got from one to the other, with a wealth of solidly grounded information—Smil’s work of synthesis saves much time in going to the original or, alternatively, points to where to go to look further. It is also a work of great interest for people interested in political thought, or philosophy, or cultural analysis inasmuch as it presents us with a clear challenge: if we are indeed coming to the close of a three- hundred- year period of transition from one steady state to another, how will that affect the way we live and order our affairs, and how must our thinking change?
*Dr. Stephen Davies is the Head of Education at the IEA. Previously he was program officer at the Institute for Humane Studies (IHS) at George Mason University in Virginia. He joined IHS from the UK where he was Senior Lecturer in the Department of History and Economic History at Manchester Metropolitan University. He has also been a Visiting Scholar at the Social Philosophy and Policy Center at Bowling Green State University, Ohio. A historian, he graduated from St Andrews University in Scotland in 1976 and gained his PhD from the same institution in 1984. He has authored several books, including Empiricism and History (Palgrave Macmillan, 2003) and was co-editor with Nigel Ashford of The Dictionary of Conservative and Libertarian Thought (Routledge, 1991).
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