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Capital Context Update: Systemic Risk Rising and Spreading
From Capital Context
IG credit and US Equities are following HY credit in its systemic derisking.
In a follow up to our recent comments on a rise in systemic risk, we note that both investment grade (IG) credit and US (S&P 100 in this case) have followed the path we expected in recent days. We pointed out the
significant rise in pairwise correlation
among the components of the high yield (HY) credit over two weeks ago and the fact that it was accompanied by spread widening and lower volumes in secondary HY markets helped confirm our negative sentiment.
Today, we see that IG and S&P100 correlations have also turned notably higher, just as we forecast, as systemic derisking has spread. The pattern is clear, we see HY break first, equities follow (which make sense given their more risky characteristics and higher beta), and then finally IG credit as systemic risk is lifting all bids.
The spread/contagion from HY to IG and equities is important and systemic in its bias - and the fact that all risk premia are rising as this pairwise correlation rises is of most note.
There is a broad derisking occurring in risk markets - as we know by looking at index values - but more importantly the internals in credit are very worrisome (
as we discussed previously
) and this correlation dynamic is one of our favorites to keep an eye on.
HY vol is low relative to Equity vol - with systemic risk rising we see HY vol outperforming (rising more) than equity vol.
Another
contextual indication that we consider is the relationship between HY realized volatility and equity realized volatility
. It has a very cyclical (mean-reverting) relationship and at current levels we are at the upper end of that relationship. We highlighted this a month ago as we reached this upper band and we are starting to see the reversion.
How do we interpret this? Simply put, we do not expect HY realized volatility to fall any further and given the relatively low levels of realized vol in equities, we strongly suggest that HY realized volatility will rise dramatically in the short-term (and gamma traders/vol scalpers in swaption land should take note). The rise in volatility in HY implicitly means (given stable leverage over the short-term) that business risk is rising for more levered firms and equity valuations should be adjusted (cashflows discounted accordingly) downward.
With realized volatility levels relatively low, and implied vol having crept lower and lower (as it tends to do every cycle) in line with this reducing realized vol, the fact that this indicator is at the upper end of the scale combined with the systemic rise in risk we discussed above, makes us very confident of long vol strategies in HY (and IG and equities for that matter) and for that matter fading the skew in options also. Most clearly for those that can position for it,
we would expect HY vol to notably outperform (rise more relatively speaking) equity vol in the short-term.
North American financials have shifted to become more risky on average that European financials but both are rising rapidly.
The third indication of systemic risk is very specifically related to financials
. We have highlighted the Financial Stability Board's list of 30 most globally systemically important financial entities before. We pointed to that having risen dramtically in the last few weeks and on a longer-context, now almost double its post crisis lows - we track a weighted average of the credit spreads of that index.
The thing of note today is that even though European sovereign risk is soaring once again on the back of realizations of necessary restructurings becoming more likely,
US financials (on average) are trading wider than EUR financials
(based on the membership of this list of 30 entities).
Aside from the brief spike in January of this year (as European financials exploded on sovereign risk expectations), the broader FSB30 index that we created is at its widest since the middle of last July.
The fact that the index is 23% higher (riskier) than it was at its most recent trough on 4/11/2011 (two months) and is at 11 month highs (risky) must be of great concern to any central bankers considering further monetary stimulus as way to juice this market (and of course the collateral pile at the ECB).
These are just three of the somewhat unusual indications that we use for contextual analysis and are admittedly more complex than others.
Our TAA model remains market neutral and therefore we are completely beta-hedged in our A-List portfolio -
which as we saw this morning
- is keeping us out of trouble for now.
Late Update:
We have been discussing the fact that credit indices have underperformed their fair-values consistently for a week or two now. We posited that this was typical as macro/broad market overlays were placed in the most liquid instruments but we were surprised by the length of time, the indices had remained cheap (wide). Well
today we note that in IG and HY credit (in both 3Y and 5Y maturities) that the underlying single-names are underperforming quite notably (most specifically in 3Y HY and 5Y IG)
. This is noteworthy as we have been concerned that the
derisking attitude we have seen would rotate from top-down to bottom-up
. This could have significant impact on both new issue markets and on the dealers whose inventories are likely high.
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Systemic Risk!
Thythtemic Wisk! Waaa! Waaa! Help Us!
Why that's Hank Paulson's favorite saying.
William Hurt , should deservedly be so, for romanticizing this Pirate.
Hoist the Jolly Roger , another round of fun...PREPARE FOR BOARD!!!
as time goes on, these problems get worse not better -
now that we're in a world of deflation, shrinking population growth in the West, and rising global competition for commodities, the money supply is guaranteed to fall (at least, money created through voluntary private market new borrowing). that means lower and lower prices, escalating defaults and bankruptcies, a shrinking tax base, and more and more and more "austerity." tax increases, transfer payments, and other "solutions" just make things worse because they aggravate deflationary pressures.
all governments can do now is try to stretch the collapse out over 40 years - and hope that things don't unwind brutally in <5 years.
We are indeed IN systemic risk. Carpe Diem...buy GOLD, take delivery
we are in systemic risk. Period. its not a thing of the future.