Non Predictions 2020

Something that has caught our attention over the past few months has been the deterioration in some components of the lower quality credit universe. First, there has been a material widening in leveraged loan spreads which have moved from a tighter spread to US high yield now to a premium. In addition, some sectors of the high yield index, most notably energy and CCC-credit, have also widened materially relative to the broad universe. Finally, on a cross market basis, we have a relative preference for US banks compared to Australian Banks from a credit and equity perspective (we will cover that in a separate note). However, our key observation is that later in the cycle investors probably ought to have a preference for quality. In addition, the deterioration in some lower quality segments of the credit universe can be a warning sign for the market cycle itself, particularly in the context of a deterioration in market liquidity (dealer inventory) and the potential liquidity mismatch in managed or exchange traded funds.

Throughout 2019 there has been a material widening in some segments or sectors of the credit universe. Most notably, the credit spreads in the high yield energy sector have widened materially compared to high yield index (ex-energy – chart 1). The good news from an energy sector perspective is that total debt relative to EBITDA in the small cap universe is considerably lower than the episode in 2016 (chart 2). Nevertheless, markets are forward looking and the widening in the credit risk premium may indicate that there is some solvency or cash flow (future EBITDA) pressure building in the sector. Of course, in the commodity sectors, cash flow is broadly tied to the spot price of the underlying commodity.

The good news from a broad high yield market perspective is that credit spreads remain relatively tight and consistent with a cyclical re-acceleration in earnings over the coming months. That said, the high yield market arguably didn’t price in the year-on-year contraction in profits over the past 12 months in the first place. Historically, high yield spreads are inversely correlated to the profit cycle as it is coincident with a corporate’s ability to refinance debt out of cash flow (chart 3). Nevertheless, if earnings recover and liquidity remains supportive, broad high yield credit should continue to perform well over the coming quarters and extend the cycle. On the negative side, US (and Chinese) corporate leverage has continued to expand relative to GDP. To be fair, leverage ratios appear less alarming on a EBITDA or interest coverage basis. Of course, that assumes there is no deterioration in cash flows; like P/E valuation multiples, credit spreads are also pro-cyclical and driven by risk perceptions.

The final point to note is that there is an intimate link between liquidity, volatility and leverage. In turn, all three factors are important drivers of the credit risk premium or spreads. When liquidity is plentiful that tends to supress volatility, encourage more leverage (market and corporate) and tighten spreads on most credit and carry assets. Importantly, both volatility and spreads tend to drift or trend higher toward the end of an economic or market cycle. Weaker sectors (or the naked swimmers) will also tend to reveal themselves first as the liquidity tide flows out. Similarly, it is also probably not a coincidence that MSCI world equities have tended to rise or fall with the increase or decrease in global liquidity (as measured below by the global USD M2 money supply). For now, liquidity remains supportive as almost all central banks have eased policy and there has also been a (tentative) recovery in leading indicators of activity and earnings. However, increased stress in some of the lower quality sectors of the credit markets can be a warning sign that the regime is a late cycle re-acceleration phase.

From our perch, pessimistic cyclical beliefs following the decline in global growth since late 2017 not only had an impact on cyclical equity markets, it also had a material impact on high yield currencies within emerging markets. On the other side, persistently low (or negative) policy rates and sovereign yields in other currencies, most notably tied to the euro, created a number of large relative value opportunities in foreign exchange. However, even in emerging markets and Asia, there are some low/negative yield currencies that are attractive funders for high carry currencies.

Relative carry trades are particularly attractive where the economies have similar characteristics and trade linkages. For example, China and Taiwan or Indonesia versus Malaysia. As we noted earlier this week, we find Indonesia (IDR) and India (INR) attractive carry relative to both Malaysia (MYR) and Taiwan (TWD). We have recently expressed these positions in the portfolio. From a carry trade perspective, incorporating economic similarities and linkages has three advantages: 1) it reduces the volatility of the cross rate; 2) it reduces the impact of the US dollar (it is less dependant on a dollar view); and 3) therefore it improves the return-for-risk of the position. While the carry trades noted above have a pro-cyclical bias, the correlation improves the compensation for risk.

Outside Asia, one of the most attractive currencies from a carry perspective is the Mexican Peso. The 1 month carry funded in euro is 8% in nominal terms annualised (chart 1). Moreover, the carry relative to volatility (return-for-risk) is the highest in at least the last 10 years. From a fundamental perspective, Mexico is one of the most sensitive countries to a rising US ISM (growth momentum) as more than 80% of production (exports) are destined for the United States. On a long term basis the real effective and PPP valuation of the Mexican Peso is back to pre-NAFTA levels despite a basic balance of payments surplus of around 1.4%. Mexico is also running a primary budget surplus of 0.7% of GDP. Mexico’s rising share of world exports also suggests that the currency is competitive and materially undervalued. In a global environment where almost every central bank is easing policy and the threshold for future tightening is high, growth should accelerate. While that may also cause an improvement in risk perceptions and core sovereign yields in Europe, Mexico ought to outperform as it is most levered to US consumer demand. However, funding the position in euros reduces the dollar risk or the potential for dollar strength to undermine the position.

As we noted earlier this week, we are mindful that the carry positions outlined above have a pro-cyclical bias or would benefit from a re-acceleration in global growth. A key risk is that while assets most sensitive to global growth are inexpensive, the S&P500 trades at a record high and cross asset volatility is near a record low (to be expected in a rising global liquidity environment). Similarly, the reason why carry-to-volatility on the MXN/EUR is elevated is that volatility is at a record low (chart 2). Nevertheless, 8% nominal carry is still attractive given that the currency is also fundamentally inexpensive. However, it is also why investors ought to consider long volatility as a portfolio hedge. If global growth re-accelerates, dollar rates could rise and dollar liquidity tighten. Alternatively, if global growth fails to re-accelerate, cross-asset volatility would also likely spike. In conclusion, while EUR/MXN carry-to-volatility is attractive, volatility itself is also inexpensive and maybe a cheaper diversifier than sovereign bonds.