One Of Worst Monthly Sell Offs In High Yield Market's 25 Year History Implies "100% Probability Of Mild Recession"
More flashing red recessionary indicators are coming courtesy of the largely ignored High Yield market, which following a 5.3% decline is, as Bank of America (itself ironically contributing substantially to the blow out) says, is shaping up to be "among the worst months in the HY market's 25 year history, in a bad company of post-Lehman, post-WorldCom, post-9/11, and post-Russia sell-offs. The difference of course is that we did not have the largest bankruptcy in history taking place (LEH or WCOM shared that title at a time), no terror attack, and no outright sovereign default (Russia in Aug ’98). What we did have however, is a global risk-off trade, sparked by concerns that this fragile environment could slip into a double-dip recession as consumer and business confidence fails to sustain repeated beating from sovereign and financial systemic risk issues." What we also did have is the near end of the modern ponzi economic model, whose viability was once again extended courtesy of a variety of sticky objects thrown at the wall with hopes one sticks. For now the obliteration has been halted, although one thing is undeniable - central planner intervention buys increasingly less and less time. We are confident that August is just the beggining of pain for not only HY, but all other asset classes. And some more ammo for those who like comparing 2011 to 2008: "Parallels are being drawn between today’s environment and that of 2008, given the degree of equity destruction that has taken place across the financial space. Financial CDS – the epitome of ’08 systemic risk – are trading at an average of 190bp in the US, within reach of Oct ’08 levels, and 240bp in Europe, well north of their ’08 wides." What do spreads imply? Nothing short of recession: "The HY index, in the meantime, has widened to 739bp as of close on Thursday, its widest level since Nov 2009. With the spread normally peaking at 1,000bps in full recessionary periods2 (1991 and 2001-02) and bottoming at 250bp in times of strong economic growth, the current level is pricing in an 80% probability of a fullblown contraction in GDP, and a 100% chance of a mild recession."
And some more disturbing observations from BAC's Oleg Melentyev:
BB-BBB spread at recessionary wides
Relative spread between BBs and BBB, which currently stands at 311bps compared to the historical average of 170bp (Figure 2). More importantly, this differential tends to peak at around 300bps in full recessionary periods (1991, 2001-02) except for 2008 market meltdown episode. In other words, judging from this particular pair, the HY market is pricing in a full-blown recession at this time, ie. there is very little downside left in this relationship, unless we get a full-blown replay of 2008, which we consider to be an unlikely development.
HY prices in a 7% default rate by this time next year
By our estimate, assuming a 30% recovery – well below recent 50%-plus readings – this market can sustain a 7% default rate over the next year and still provide investors with 270bp of excess spread – the historical average compensation over future credit losses it offered over the past 25 years (Figure 1).
Our views going forward
The risk of seeing the US and EU economies slipping into recession has increased significantly over the past few weeks and we will be watching incoming high-frequency economic data very closely as we weigh any changes to our default rate and spread forecasts. Even more importantly than econ data, which will only show the picture ex-post, it is extremely important to see recent volatility in markets and wealth destruction it brings coming to an end. Today’s worst reading on UMich Consumer Confidence index in 30yrs is a blunt reminder of dangers the uncertainty brings whether it comes from Rome, Washington, or New York, let alone when it’s all of the above.
And now, the media's spin job, should it choose to accpet it, is to spin a "mild recession" as bullish for stocks.
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