December 2015 – Credit – Rising risks, US HY turmoil and market refrost

For most of 2015, we have considered that risks were broadly balanced in European credit markets as Europe was less advanced than the US in its credit cycle, while market technicals and investor risk appetite were generally supportive. Getting into 2016, we have taken a more cautious stance as we see risks being increasingly skewed to the downside.

More and more question marks for the credit outlook of corporate Europe

By and large, our view on European credit fundamentals remains positive as the economy continues to perform decently and with less dispersion within the region. Such trend is underpinned by lower energy prices, a more favorable exchange rate and a supportive interest rate environment. However, a closer look at fundamentals highlights areas of weakness and the potential for credit accidents. The slowdown in China and the troubles in many EM economies make the credit profile of certain European IG and HY corporates with significant investments and exposures in those regions more vulnerable. Similarly, the turmoil in several commodity markets creates negative headlines for a limited though high-profile number of natural resources groups. Importantly, the current market volatility and financial stress are also putting additional pressure on the weaker sectors and credits. This matters a lot as 4 years of huge HY market expansion in Europe have brought many names with fragile business models and overleveraged capital structures to investor portfolios, which will likely be the first shoes to drop in a more challenging environment. Similarly in IG, the number of rating downgrades may increase as a result of such risks and of more frequent credit-unfriendly corporate actions.

One sector where we retain a positive outlook for 2016 is the banking sector, as we expect most management to continue to execute creditor-friendly strategies. Although such positive trend has been well-entrenched for many years now in Europe, we believe that it still has more to give as many changes in the liquidity and solvency profiles of European banks take time to be implemented. With limited concerns on asset quality for the moment, greater clarity on the post-financial crisis regulatory environment and much stronger balance sheets, the outlook for the credit fundamentals of European banks remains highly favorable, in our view.

The turmoil in US HY is making the European credit clock move faster

In addition to our – limited though real – concerns on credit fundamentals, we are also turning less comfortable on the level of support offered by market technicals and investors’ risk appetite to our market. Arguably, the ECB will purchase at least €720bn of EZ fixed income assets in 2016 – thus generating at least €400bn of excess liquidity to be redeployed in non-eligible assets – and may well, in our view, enhance such QE program, but we see growing risks on those fronts too.
First, the efficiency of central banks’ unconventional policies on the real economy and financial markets seems to be diminishing since the aftermath of the great financial crisis. Although we welcome the support provided by the recent ECB’s QE extension to credit markets, it will not be the game changer it was at the end of 2014. Second, we think that renewed political risk may arise in a less stable financial environment, which may in turn create market jitters. Specifically for Europe, there are at least three areas of focus in that respect: Spain – with a hung parliament and the Catalonia independence movement, Greece – with a demanding reform agenda to be implemented in the context of huge macro imbalances – and the UK – where the referendum on EU membership may place the second largest economy of the region in unchartered territory. Third, the significant reduction in market liquidity over the past few years may act as a deterrent to additional risk taking by market participants in the context of the various uncertainties already discussed. Last, the expected pattern of upcoming systemic defaults among the energy and commodity-related issuers of the US HY market – a subset of the market accounting for ca. 20% of the nominal of bonds outstanding – may well create fears about more global credit market disruptions which, in turn, could drive a more general pullback in investor risk appetite. Witness the market reaction to the announcement of the shutdown and/or gating of several US-based credit funds in December to understand how a fire in a large but contained segment of the US HY market may have broader negative repercussions on the ability of European HY borrowers to get access to debt capital markets. If sustained, those shocks could accelerate the last innings of the current European credit cycle and prompt a repricing of credit markets wider.

Today, a market refrost. Tomorrow, a market selloff?

It is worth noting that we have not reached that point yet and that there is no certainty that we will in 2016. That being said, European credit is now more vulnerable to external shocks and the risks that such potential shocks would occur are definitely on the rise. Importantly, it seems that European credit funds are generally long cash, have taken limited losses in the past few months and have not faced significant redemptions. As a result, we have traded in a HY market which is in the process of freezing as opposed to falling apart in the past few months. This means no major outflows and no panic selling so far, but it also means very limited activity in primary and credit spreads drifting wider.

However, the repricing in European HY appears insufficient to us, especially as the valuation gap in credit spreads with the US HY market could make it less appealing to global investors – even adjusted for issuer composition. Looking forward, we believe that it would not take much of the risks which we discussed earlier in this letter to materialize to ignite a more brutal selloff and repricing in European HY.