In today’s Macro Briefing Top Down Charts examines the TIPs market where breakevens look to be in the process of breaking higher with a number of prospective tailwinds, while Vincent Deluard of INTL FC Stone sets out a method for how investors can profit from this era of financial repression. MI2 Partners take a closer look at the US real estate marke, where on the face of it brisk suburban and mortgage activity suggests residential real estate is in rude health, but looking under the hood reveals quite the opposite. The final two pieces we highlight today focus on credit where Ned Davis Research assess where the investing opportunities lay along the credit spectrum. Most of the money has already been made in IG since March, but are investors brave enough to go all in on high-yield yet? Finally, Goldman Sachs examine the potential of systemic credit risk emanating from the CLO market and conclude that it is no canary in the coal mine.
Substantive's Top Themes - Best of the Broker Notes
1. Is there any juice left in IG credit spreads?
Joseph Kalish at Ned Davis Research has recently reiterated his market weight view on corporate credit, but says the almost relentless up move since the March lows has left him wondering whether he should upgrade again to overweight. He has therefore taken a broader look at the indicators, what they are currently saying, and what might cause him to change his position. On an absolute basis, the picture is mixed, according to Kalish. He believes there’s not much value left in investment grade, whereas high yield has better value but more risk, as credit fundamentals and pricing power remain weak. That said, Federal Reserve support, strong inflows, high cash levels, and improved risk appetite limit the downside, says Kalish. Reflecting these divergent trends the technical picture is mixed, he says, with the continued outperformance of high yield relative to Treasuries and broader US aggregates supporting a potential credit overweight, while a high yield overweight needs a better CCC performance and for high yield to outperform investment grade.
2. Why CLOs are not a canary in the coal mine
Despite the notable improvement in risk sentiment, concerns continue to mount that pressures in the leveraged loan and CLO markets could weaken the ongoing recovery via tighter financial conditions, says Lotfi Karoui at Goldman Sachs. He says the most frequently encountered concern is that the relative rigidity of CLOs coupled with the strong dependence of leveraged loan issuers on CLO demand, could constrain credit availability. Some observers have also recently grown concerned over the risk that coupon and principal impairments on CLO securities could have systemic ramifications via leveraged losses in the banking system, adds Karoui. Accordingly, he has addressed those concerns in a Q&A format. Karoui says he doesn’t view CLOs – and more generally, leveraged loans – as a source of macro vulnerability, particularly given the healthy dose of policy support that has been injected into credit markets. And while he continues to recommend an underweight allocation on leveraged loans versus HY bonds, the drivers of this recommendation are fundamental in nature and do not reflect concerns over the risk of a systemic shock radiating from CLOs. Within the CLO market, Karoui continues to see value in senior bonds, especially the A-rated part of the capital structure, which he thinks offers an attractive combination of higher carry and low risk of principal write-downs.
3. US real estate – a pandemic of just a cold?
Julian Brigden at MI2 Partners says brisk suburban and mortgage activity suggests residential real estate is in rude health, but warns with finance tightening and weak urban activity, momentum might not last. Meanwhile, he says, cash flow and debt are huge problems for the commercial real estate sector, while city office space could be impaired for years to come as firms embrace the new normal. Like the broad market, some real estate assets have rebounded sharply, driven by Fed liquidity, fiscal stimulus and a narrative of recovery, explains Brigden, yet the reality is that narrative is mostly a function of the rate of change in the numbers, not their level or longer-term prospects. Unfortunately, he says, at some point, that trajectory will flatten, and underneath the hood, all is not well. Admittedly, says Brigden, a few sectors are currently strong, such as suburban COVID boltholes, but even here he says much of the apparent strength seems to be a function of limited inventory, the delayed spring market and some of the lowest single-family mortgage rates ever. If credit availability doesn’t revert to prior levels quickly, says Bridgen, it can’t be maintained. And that’s the better news, he says, because when it comes to the retail and office sectors, real estate is a train wreck. Perhaps the Federal Reserve will eventually design a programme for that market too, says Brigden, but finding a one-size-fits-all solution for a $16trillon-plus, highly location-specific market won’t be easy
4. How to profit from financial repression
Financial repression in the form of yield curve control is the most practical solution to the certain risk that the Federal reserve will not be able to monetise structural deficits of $2 to $3 trillion a year indefinitely says Vincent Deluard of INTL FC Stone. He says anchoring long-term bond yields at low levels should increase risky assets’ valuations and reduce their volatility. However, notes Deluard, central bankers cannot control economic and macro risks, and volatility, which is suppressed most of the time, comes back in rare but devastating spikes as price adjustments must happen all at once. As evidence, he points to extended periods of sub-5% annualised volatility for the S&P 500 index and notes six of the nine biggest spikes in the Vix index have taken place in the past three years. This “nothing-at-all-for-a-long-time-and-then-all-at-once” pattern in volatility has resulted in a downward trend for the Vix index and an upward trend for the CBOE Skew index, as investors pay a premium for protection against “black swan” events, he says.
5. TIPS set for rebound
After rebounding from extreme cheap levels, TIPS breakevens look to be in the process of breaking higher with a number of prospective tailwinds in play, according to Callum Thomas at Topdown Charts. In terms of broader inflation expectations there seems to have been a broad-based nadir put place already, with surveyed inflation expectations more or less recovering all the previous ground lost since the peak of the panic over the possible effects of the coronavirus pandemic, he says. Indeed, according to Thomas, it looks like markets over-reacted in terms of the deflationary downdrafts, and to the extent that surveys are providing an accurate read of inflation, he anticipates some catch up potential for market-based measures of inflation expectations – in other words TIPS breakevens. Looking further out, if and when all the monetary stimulus and easing of financial conditions gains traction, says Thomas, the ISM manufacturing PMI could be sent a lot higher over the next 12-18 months: placing a more fundamental macro tailwind behind inflation expectations on the other side of the pandemic.