As strange as it may seem, the current market environment of highly correlated risk assets and surge/plunge movements in prices does indeed lend itself to the contrarian view that Citigroup's credit research group has to 'do what feels wrong' in 2012. This has proved very profitable in the last few months and they warn that the consensus view that 'its okay to miss the first leg of the rally, I'll catch the second' may be a losing proposition as the current chase we are seeing in the last few days (and saw on 11/30 for example) exemplifies the rapid one-way shifts in credit, equity, and in fact every asset class at the merest hint of solution (or problem). Citi lays out five scenarios for 2012's credit market (and the concomitant equity markets) basing their opinion on market (VIX and rate level and vol movements) as well as fundamental (the economic surprise index we have been extensively discussing), and technical (issuance and trading volumes) and see spread compensation for default as negligible and mostly prone to systemic risk which should disappear in the low probability 'very bullish' scenario. The highest probability scenario is continued sovereign stress (or a decade of deleveraging), which we agree with, and a very range-bound trading market as systemic risk remains high (though not cataclysmic) with the floor on secular spreads notably higher than pre-crisis levels. We do wonder though when we see spreads 'switch' regimes from reflective of systemic risk to reflective of fundamental (recessionary slowdown) cyclical risk.
5 Scenarios for Spreads in 2012
Our base case for corporate spreads must be cognizant of both the likelihood that Europe is slowly resolved, at best, and that the equilibrium level of spreads going forward is likely to be higher than during past credit cycles in order to reflect greater vulnerability and a secular deterioration in liquidity. As such, we envision spreads trading within a relatively wide range of 160 to 220bp throughout much of 2012, provided the Eurozone remains intact – a big qualification.
At 240bp, Citi’s US Broad Investment Grade Index (US BIG), looks cheap under the base case scenario. In fact, we see a high probability of generating excess returns of at least 380bp (240bp of carry, 20bp of spread tightening) and the potential for 840bp should spreads end the year at the tight end our range – which seems unlikely given the volatility fourth quarter elections may create.
Our basic approach to spread forecasting involves dividing the index spread into two categories: the compensation for default risk and the compensation for non-default risk. To do so, we appeal to macroeconomic default forecasts. In particular, Moody’s has been providing a one year forecast for each rating’s category every month for the last five years. We apply that forecast iteratively to generate default probabilities for each ratings category and then use those probabilities to determine the worth to investors in basis points (Figure 12). The compensation for non-default risk is then calculated by subtracting the spread compensation for default from the current spread of the high grade index.
Focusing just on the non-default spread compensation in high grade can be very instructive. We find that this series of spreads can be easily modeled using five variables: the VIX, the level of 10-yr swaps, the volatility of 1-yr swaps, high grade trading volumes, and Citi’s economic surprise index (Figure 13). The first three of these variables are the biggest drivers (in addition to being the most statistically significant) and their values tend to capture changes in systemic risk.
When forecasting then, having a view on volatility and rates can go some way to determining where high grade credit should trade when assets prices are so highly correlated – as they are now. Moreover, since the spread compensation needed to protect against default is so low (we figure just 5bp), nearly all the spread one sees in the market is compensation for systemic risk, not fundamentals. This conclusion shouldn’t come as a surprise to investors, as it is equivalent to saying a resolution to Europe’s ills could be worth 80bp.
More formally, we outline five scenarios for spreads in 2012 (Figure 14) along with some indication of how probable we think each is.
Consensus among investors seems to be “it’s okay to miss the first leg of the rally, I’ll catch the second”. Ultimately, this strategy could prove ill judged. It is our contention that the current risk on/risk off trading environment will make it difficult to capture any potential relief rally, and that spreads will ultimately plateau at a much higher equilibrium level than before. In other words: There may not be a second leg to the rally - at least not in 2012.
For some time now, the best strategy for taking advantage of spread volatility has been to do what feels wrong. We continue to think abiding by this rule will prove profitable. Our range of 160bp-220bp argues for buying high grade bonds when the index is trading wide of 220bp – as it is now – and gradually selling as the index tightens toward 160bp.