Market Evolution and “Considerations En Plein air”: An Update

The markets are digesting news, economic data and geopolitical events, which are characterizing and shaping the world towards the end of this complicated year and into the next. Forming expectations for long periods is close to impossible. Central Banks have stopped providing financial markets with guidance about future monetary policy intentions due to current uncertain times, hence investors shorten their investment horizons. This is true for liquid assets: govies, credits, stocks, commodities. U-turns on policy signals have been the new normality over the last quarters from all sides of the world. Central Banks – for avoiding embarrassment or for not locking themselves into misguided communication – changed their actions by using a “meeting by meeting approach”, leaving investors navigating strategies in a complicated environment. The markets have severely underperformed in many compartments and sectors with movements not seen in decades. Short-lived risk-on moments are overshadowed by risk-off sentiments lasting weeks and months.

The U.K. had another week of political turbulence: I am sure many people in the country are watching the current happenings with trepidation, disconcert, anger, even sadness. If you are an investor, I advise to adopt a negative bias to the U.K. market. Much can be said about the “liability driven investing” strategies (LDI) of the pension industry, about the PM’s resignation, a new political leader, the government’s ill-fated, watered-down fiscal plan, or the BOE statements. What I will say is that this is a humiliating and depressing situation for the country. It is important, as I wrote last time, to stop the Voodoo-economic theories as soon as possible and return to orthodox economic plans that balance the books of the country. The U.K. government and the dismissed PM have been forced to react to the dissatisfaction of the financial markets that have clearly opposed the mini budget plan presented at the end of September.

Liz Truss has resigned, but in my opinion, the U.K. credit markets remain a big “short trade” at this stage with few exceptions. The credit compartments for IG and for HY bonds have severely underperformed YTD the equivalent categories in the Euro area. This negative trend has accelerated since end of September, as obvious, but there is still room to go south, especially in the sub-investment credit buckets. Some credit sectors that underperformed Europe by only 2-3% should see further negative corrections of 6-8% magnitude. The correction in the IG U.K. fixed income world came so far from the impact of rates in the 5-30Y segments, which saw big shifts higher in the GILT curve.

Like everyone knows, the U.K. bond market went into a tailspin after the announcement of Truss’ fiscal plan. But the story is not over yet. I fear how the credit markets are still underestimating the recession headwinds, which are going to hit the U.K. economy and especially the HY space. This is the reason behind the negative call on this market and in my previous post I described the U.K. as being “uninvestable” because of the unknown risk premiums. The fire sale dynamics I have seen in the last weeks from many desks (involving British assets but not only) might slowly diminish and the market confidence might be restored, but the structural risks remain, and the volatile trading conditions will continue. Assessing market risks and credit factors is paramount: the earnings season should help credit managers in shaping the investment positions in sterling credits.

44 days after “the design and the set-up of a vision of low tax and high growth” for the U.K. (“in the freedom of Brexit”), we are back to the beginning. A complete market meltdown has been avoided, but the current backdrop of financial vulnerabilities remains in place. Europe is not in a better situation and the credit dispersion between the continent and the U.K. remains the prevailing theme for the credit markets.

What lessons can be drawn from the current volatility in rates? Investors have understood and deduced how high long-term rates will have a deep impact on households and businesses. Many years of low interest rates have changed the way investors looked at opportunities in the credit space. In October 2022, after a yield curve correction of 10 months, the same investors are now pondering if from the current yields we will have a slow grind higher rather than another sharp rate repricing. Some people are even arguing the ceiling has been reached. I am in this camp for what concerns the 5Y tenor and further along the curve.

For the credit markets this implies a big difference and a change in tone: some long-term bonds in the IG and BB space are gaining attraction and many investors are “fishing” again into Additional Tier 1 (AT1), a market of over Euro 200 billion and into insurers’ sub-debt. I wrote about these asset classes for months, suggesting plenty compelling opportunities, and I finally see big flows into short call and high back-end sub financial debt.

Many of my colleagues still think about iTRAXX Crossover and stock market prices when they consider and study the AT1 paper. I agree these give guidance to understand the value of this asset and to minimize the portfolio variance of AT1 notes with the appropriate hedging combination of index and shares, as I have recently commented in few notes for a model developed by an ex-colleague of mine, a senior analyst for a Nordic Bank. But in the first days of October something new and different happened. The “rate play” roared back with force and the depressed subordinated bank debt, which previously lagged other beta credits in short rallies and dropped more than other assets in bearish risk reprices, started to outperform the credit market with sustained demand.

It was more than the unwinding of short positions. Investors deemed the extension risk was fully priced and they reappeared in the market with a focus on value, fundamentals and convexity. The primary issuance of Permanent TSB Group was allocated without issues also thanks to the generous coupon (the highest ever seen) and spread on the curve. It is difficult to cite evidence in support of macro events as the driver behind this shift in attitude: I’d like to think it is related to technicals like rates levels, scarce supply of new issues, and the fact that the investors now involved in the asset class are the real players in the field able to assign the right value to the best risk-return notes. Credit Suisse’ restructuring headlines and the no-call of Sabadell 6,125% AT1 did not alter the big picture or spook sentiment. Two-way trading is possible in most of the AT1 securities with a skew on the buy-side even in the circumstances where weak price actions are prevalent in the HY cash market.

Looking ahead to the medium and short term, investors should continue to watch the regulatory framework and news around CS’ restructuring. For other bonds, the BB cohort with 5-10Y maturity should see meaningful investor engagement appearing relatively soon. The 5Y remains the most interesting area of the yield curve for rate and credit considerations.

I finish with a line on REITs, the worst performing asset class in the corporate world in 2022. There is a lot of superficiality and misunderstanding of the sector, which is on the contrary one of the most heterogeneous among the credit industries. I remain positive on many names in the senior part of the capital stack even on the most turbulent names. Prudence should be maintained on the Hybrids REITs for intrinsic value as well as relative consideration against other instruments.

Author: Sergio Grasso , director at iason

Previous Market Views available?here