Capital Context Update: Merry Month of May, Not!

From Capital Context

The S&P lost 18pts in May as IG credit spreads were stable. HY widened a worrisome 25bps, notably underperforming on a relative basis.

May proved the Almanack and every other old-wife right as it saw underperformance in equity and credit markets. Most interestingly for us is the relatively large underperformance of the HY market relative to IG and equity markets which were much more sanguine despite worsening macro situations globally.

'Good is good and bad is better' seems to have been the trading theme of the last week or so as performance for the month was saved from a far worse fate thanks to forward-looking expectations of renewed growth or QE3 - whichever fits your long-only investing bias better.

We sound a little jaded in that comment but as should be clear from the chart above, the excitement in the S&P of the last week or so seems considerably more 'standalone' than in the credit markets - which we are told are so critical to the continued performance of this 'recovery'.

In context, comparing the relative HY and IG moves to their 50-day rolling beta, we see that
HY underperformed by around 25bps
. Interestingly, based on short-run empirical betas between IG, HY, and the S&P,
stocks outperformed HY by an equivalent 7.6bps
, and
stocks underperformed IG by an equivalent 2.8bps
which fits with the
up-in-quality and up-in-capital-structure theme
that has been so evident all month (and in fact since late March).

European financials were the significant underperformers in credit land
as they widened 27bps to 157bps dragging Main 6bps wider overall as non-financials widened only 0.5bps on the month - much more in line with IG than Main's +6bps would have one believe. Given this adjustment in Main, a theme of HY/XOver underperformance and curve flattening relative to IG/Main outperformance and curve steepening is evident. We have discussed this at length and noted its cyclical significance in terms of both credit and the business cycle (for HY that is) and note our recent more in-depth discussion of the virtuous cycle in IG spreads/curves/bonds/basis that is starting to show some cracks as we end the month.

EU Sov bonds were mixed
with Spain underperforming (yes Spain) at +43bps in the %Y spread over Bunds relative to Portugal's 7bps widening and Greece's 15bps compression. CDS were also mixed but all the PIIGS were wider on the month as the CDS-Cash basis compressed significantly in Greece and Portugal (though not Spain). The basis is worth watching closely as we mentioned in today's closing context for signs of rotation at the margin from these highly stressed assets.

CEEMEA sovereigns were mostly wider
with Ukraine, Turkey, and Russia underperforming more in sync with commodity price drops than their Western European cohorts.

Our contextual model shows how the equity side of the market has been preferred until recently but performance in May was mixed with several sectors reverting.

In the US, contextual performance was very mixed across the sectors
even though top-down it was more unidirectional in favor of credit. The longer-term trend (from Jackson Hole) of equity outperformance appeared to have stalled for many sectors. The chart above shows a smoothed fit for the relative richness/cheapness of the various S&P sectors based on our credit/vol/skew/equity model. A positive indicates our model implies there is upside in the sector's ETF (based on credit and vol) while a negative implies the sector's stock valuation is expensive on a relative basis.
Simply put, the higher the line, the cheaper the model considers the stock of the sector relative to the rest of the capital structure (and the lower the line, the more expensive).

The raw data is noisy (drop us a line if you would like it) and we tend not to use it for signaling, preferring instead our
factor-model-based sector scores
for more tactical weightings, but it does provide a useful bias for short-term trades and general preferences in the market. The red arrrow from
last May shows the growth scare and the notable shift of stocks back into a more realistic relative-value with credit and vol
(i.e. we see a relative move UP to equities being cheap relative to our context model). The green arrow shows a
clear trend to down-in-capital-structure (take more risk) momentum that QE2 tended to infer upon market participants
(i.e. we see a relative move DOWN as equities become increasingly expensive in our contextual model) - remember these are unique sector-by-sector models of credit/vol/skew/spread and give perhaps a more clear indication of the risk premia preference of market participants.
It is clear that in the last few months that this trend has shifted
.

During May, Staples, Utilities, and Healthcare stocks outperformed (moved more expensive) while Energy and Financials (became cheaper).

As we stand at the end of May, our contextual model sees Financials and Materials modestly cheap (4% and 2% respectively); Healthcare, Staples, and Energy all more than 6% expensive; and Tech, Utilities, Industrials, and Discretionary around 4% rich. These numbers are more for relative perspective than black/white views but it is clear that the recent preference for Healthcare, Staples, and Energy that has been a clear trend in stocks has been a move far in excess of credit and volatility market's perspective (and vice versa, Financials have been hit harder in stocks than in credit and vol relatively speaking).

A view of May's specific moves in the sectors from this model's perspective maybe highlights this a little clearer. The
chart above shows the relative performance of the sector's stock to the rest of the capital structure. Staples for instance have moved 3.6% higher than our contextual framework (which once again is based on credit, volatility, and skews) would have expected and Energy fell 2.7% more than expected.
This shift must be put into context from the previous chart though as Energy is pulling back closer to 'fair-value' while Staples are becoming more and more expensive and Financials increasingly cheap.

There was a clear preference for credit in the better quality names. Very low quality cohorts were dominated by idiosyncratic disconnects (dispersion is rising).

So top-down
, sovereign risk rose, dragging financials with it in Europe. High yield spreads in Europe and the US underperformed both investment grade credit and equity markets overall quite significantly. High yield markets saw their term structures flatten at the front-end. Investment grade term structures continued to steepen with compression at the front-end and decompression in the 5Y and beyond. Investors preferred investment grade credit risk to equity or HY risk and extended duration quite aggressively in TSYs (curve flatteners). Close-to-close changes were not dramatic though aside from in HY markets as the last few days saw equities rise phoenix-like even as credit languished.

Bottom-up, breadth was slightly negative in our broad CDS universe
overall but was more balanced in the universe we track for capital structure context. 55% of CDS were wider versus 56% of stocks lower and 80% of vols higher. Credit was a clear outperformer of equities at the better-quality end of the spectrum and less so in the crossover space with idiosyncratic issues causing volatility in the relationships for the more distressed names. Low beta names outperformed in both CDS and equities (with high beta stocks actually net losers on average for the month against a small net gain on average for our low beta stocks) but idiosyncratic issues dominated among the higher beta and wider spreads as
investors are really starting to discriminate more aggressively
.

Secondary bond markets
saw similar themes with
net selling
over the course of the month of around $103mm dominated by Energy and Consumer NonCyclicals. Financials and Consumer Cyclicals saw the largest net buying on the month as the 3-7Y maturity bucket saw the largest net buying (which fits with our curve/basis trade these above) with the 7-12Y range seeing the most selling. As we see above for the CDS vs Equity context, secondary bonds showed dramatically large net selling in the crossover space (specifically BBB+ to B-) as A- to AA+ dominated the net buying. If we squint just a bit, we see a slight pattern across ratings with IG mandates perhaps pulling away from the wings to the center of the group and the same in HY mandates (perhaps avoiding the apparent richness of the quality ends of their respective spectrums and the risk of the lowest end of the ir respective groups) - this fits with the lower dispersion in IG but not so much in HY where tail names are really underperforming in CDS.

The bottom-line for May is that performance was not so bad. Investor risk appetite is definitely shrinking though
and the themes we have been harping on will re-emerge - and we remind readers of the potential for
problems should IG see any issues with its
virtuous cycle
which we talked about last week
). Fundamentally, we feel nothing has changed our net thesis (in fgact they have confirmed our view) and markets are moving in our diredction but not enough to warrant covering yet. We are watching new issue concessions, HY spread reactions to fund flows, equity-debt contexts, and sovereign bases for clues while sticking-to-our-knitting with HY-IG decompression, our ETF Arb (short stocks, long credit) for a trade, we are tactically underweight stocks top-down, and our A-List is handily outperforming the S&P 500 for May.

Index/Intrinsics Changes from April 29th

CDX16 IG
+1.75bps to 89.5 ($0 to $100.39) (FV +0.29bps to 88.21) (59 wider - 65 tighter <> 72 steeper - 48 flatter) - No Trend.



CDX16 HVOL
-2bps to 147 (FV +2.92bps to 147.37) (17 wider - 13 tighter <> 17 steeper - 11 flatter) - No Trend.



CDX16 ExHVOL
+2.93bps to 71.34 (FV -0.5bps to 70.28) (43 wider - 53 tighter <> 40 steeper - 56 flatter).



CDX16 HY
(30% recovery) Px $-1.19 to $102.19 / +28.3bps to 446.5 (FV +25.38bps to 432.62) (72 wider - 28 tighter <> 21 steeper - 78 flatter) - Trend Tighter.



LCDX16
(70% recovery) Px $-0.75 to $100.78 / +18.88bps to 248.48 - No Trend.



MCDX16
-9bps to 119bps. - Trend Tighter.



ITRX15 Main
+5.96bps to 102.5bps (FV+6.36bps to 105.26bps).



ITRX15 HiVol
+3.15bps to 139bps (FV+6.32bps to 138.92bps).



ITRX15 Xover
+16bps to 370bps (FV+12.34bps to 356.48bps).



ITRX15 FINLs
+27.35bps to 156.75bps (FV+20.83bps to 152.09bps).



DXY
strengthened 2.2% to 74.54.



Oil
fell $11.08 to $102.85.



Gold
fell $28.4 to $1535.3.



VIX
increased 0.7pts to 15.45%.



10Y US Treasury yields
fell 22.6bps to 3.06%.



S&P500 Futures
lost 1.01% to 1346.

Among the IG names in the US, the worst performing names (on a DV01-adjusted basis) were RR Donnelley & Sons Company (+66bps) [+0.48bps], SLM Corp (+20bps) [+0.15bps], and Computer Sciences Corp. (+15.5bps) [+0.12bps], and the best performing names were Safeway Inc. (-15bps) [-0.12bps], Motorola Solutions, Inc. (-14bps) [-0.11bps], and Sara Lee Corp. (-14bps) [-0.11bps] // (absolute spread chg) [HY index impact].

Among the HY names in the US, the worst performing names (on a DV01-adjusted basis) were PMI Group Inc/The (+408.27bps) [+3.02bps], K Hovnanian Enterprises, Inc. (+432.4bps) [+3.02bps], and Sabre Holdings Corp (+191.44bps) [+1.72bps], and the best performing names were MBIA Insurance Corporation (-202.47bps) [-1.5bps], Dean Foods Co. (-67.86bps) [-0.65bps], and EL Paso Corp (-52.5bps) [-0.58bps] // (absolute spread chg) [HY index impact].

Among the European IG names, the worst performing names (on a DV01-adjusted basis) were Banco Popolare SC (+52.86bps) [+0.4bps], Banco Santander, S.A. (+45.75bps) [+0.35bps], and Banca Monte dei Paschi di Siena SpA (+42.99bps) [+0.33bps], and the best performing names were TNT N.V. (-13.85bps) [-0.11bps], BAE Systems Plc (-9.5bps) [-0.08bps], and Rentokil Initial Plc (-9.65bps) [-0.08bps] // (absolute spread chg) [HY index impact].

Comments

[disabledvet]

"risk appetite is shrinking."  code word for "who the phuck is making money in this jalopy?"  i think the actual term is "issuance is down" although my personal favorites are "demand destruction" and "loan demand is basically non-existent."

[pat53]

OOOHHHH, the SPX lost 18 points, how utterly trajic... LOL  The SPX will be at 1400 by July, as more bear bodies litter the landscape. Kepp shorting, I love it  ... LOL

[CapitalContext]

Rather than double-post, a quick summary of the weekend's contextual action across credit and equity can be found here - highlighting the late surge in equities (almost alone), the activity in European sovereigns (notably with basis compressing), and the preference for high beta names and sectors late on today as equities handily outperformed a 'stunned' credit market.

[Orly]

Most of those moves had to be from institutionals trying to scrape something from a losing month, correct?

Would you expect that, since the Euro was just hung out to dry in the name of core European sovereign debt (read: German bankers...), that the trend towards higher quality paper would accelerate in the coming month, making the situation in Greece, Portugal and Spain that much worse?

Thanks.

:D

P.S.  I noticed the spreads in your stock sector charts seems to be growing wider and more erratic.  Do you have a model that may indicate the higher likelihood of a major correction based on those spreads?