Marcuard's Market update by GaveKal Research
Over the past five weeks, the spread between US high yield debt and US Treasuries has widened by almost a full percentage point. Admittedly, this move could be dismissed as an overdue correction after spreads for high yield debt narrowed to unsustainably tight levels. Unfortunately, it seems that equities markets are no longer in such a forgiving mood. In the past week, the widening of high yield spreads has weighed heavily enough on equity markets to push the Dow Jones, Eurostoxx, Dax, and CAC40 all into negative territory for the year. More surprisingly, this 1ppt jump in US spreads has occurred against a backdrop of a) solid economic growth in the US (as shown by the recent GDP numbers), b) very decent corporate profits, c) a complete absence of any significant US bankruptcies and d) no meaningful change of tone from the Federal Reserve on its zero interest rate policy.
So what explains the pullback? There are several possible culprits:
- The Fed’s tapering? The most obvious explanation for the markets’ recent behaviour is that the Fed is injecting smaller and smaller amounts of liquidity into the system and that within two months it will have finished its liquidity injections altogether. In the weeks that followed the end of QE1 and QE2, markets suffered severe wobbles, so perhaps we should expect more of the same this time around. At the very least, perhaps we should expect markets that are priced for perfection—as junk bonds have been—to move back towards fair value and for the Fed to remain largely inactive as this happens.
- Bad news on banks? Bank shares in Europe and the US have underperformed markedly in recent months. Contributing to this underperformance are increased regulatory pressures and punishing fines, as well as the need for banks to continue writing off dodgy investments from the past (especially in Europe). Could this be weighing on the junk bond markets? If banks have less capital to back loans, or less inclination to take risk, then high yield debt becomes the one source of funding for cash-starved corporations.
- Bad news from Europe? The post-2008 crisis spikes in spreads (in the spring and summer of 2010, 2011 and 2012) were mostly linked to the unfolding of the European crisis in which weak banks dragged down sovereigns in a relentlessly vicious cycle. However, when Mario Draghi replaced Jean-Claude Trichet at the helm of the European Central Bank and promised to do ‘whatever it takes’ to keep the euro-show on the road, the market started to price an end to the weak-bank/weak-sovereign vortex. Unfortunately, with the nationalisation of Portugal’s Banco Espirito Santo, questions are again swirling about the size of the haircuts debt-holders will have to take in the event of bank bankruptcies, and how much of the losses should be borne by overly indebted tax-payers.
Still, what is interesting about the recent pull-back is that, unlike last summer’s taper tantrum or the 2010-12 summer sell-offs, this time around Asian equity markets seem to be taking it all in their stride. Last month, Chinese equities were up 6.6% (partly on the back of Chinese bank recapitalisation and RMB strength), while Korea’s Kospi broke out to new post-crisis highs. This resilience of Asian markets in the face of weak Western markets and widening spreads is impressive. It also comforts us in our belief that the recent pullbacks may not be linked to any structural problem with global growth per se, but instead may be a direct consequence of a post-tapering repricing of assets and/or an acknowledgement by markets that the eurozone economies remain structurally challenged.
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