Deutsche Bank's Oleg Melentyev is worried...
"This is quite an unprecedented set of circumstances to have a very strong market move tighter that is not led by its higher-beta components. It also gives us a sense of a low level of conviction prevailing among market participants: I don’t want to miss out on the rally and yet I don’t want to touch the high-octane stuff, even ex-energy, as my confidence in issuer fundamentals and persistent lowdefaults is diminished. "
In fact, three things are on his mind that warrant some very serious attention...
Figure 1 shows how CCCs are now underperforming BBs on a trailing 12-month total return basis, by 700bps all-in and 460bp ex-Energy. There are only three instances of underperformance this deep, two of them coinciding with developing credit cycles in early 2000 and early 2008, and one false positive in late 2011. We have previously addressed the latter case in our Evolution of the Default Cycle piece a few weeks ago, pointing at its differentiating features such as early cycle stage (only 2 years out of the previous recession) and easing policy stance (the Fed expanding on its QEs, not rolling them back or hiking rates).
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Another interesting and unusual development is taking place on a high-level across asset classes, where US HY is now underperforming all major related markets, Including loans (-1.2%), IG (-0.5%), equities (-2.1%), Treasuries (-6%), EU HY (-3.7%) and even external EM sovereigns (-4.3%). The most intriguing detail here, in our view, is that HY is underperforming both IG and equities at the same time. Think about how unusual this is for a moment. If HY is an asset class that sits somewhere in the middle on a risk scale between high quality bonds and equities, then normally we would expect it to be underperforming one and not the other, as they would normally move in opposite directions. Figure 2 confirms this intuition – plotted here are the trailing 12mo differentials between HY and IG (blue line) and HY and equities (red line), and most of the time these two lines are on the opposite sides of the x-axis. In fact, the only two times we had both of them being negative were, again, early 2000 and late 2007. Even 2011 did not create an exception here. The graph looks indistinguishable if we were to plot all three asset classes ex-energy over the past year.
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Recent disappointing results announced by retailers ranging from Walmart to Macy’s to Nordstrom to Best Buy has also caught our attention as an odd development. Somehow, we were under the impression that these were supposed to be the best of times for the US consumer: employment trends are strong (as evidenced by nonfarm, claims, and unemployment rate), wages are going higher (21 states raised their minimum wages in 2015, as well as some major private employers such as Walmart, McDonalds), gasoline prices are at 10 year lows as are home heating bills, equities are at cyclical highs, and home values have recovered. So if consumers are cutting on their discretionary spending with all these tailwinds in place, there must be something else going on.
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Part of it is the “Amazon” effect, where any retail sector graph is a mirror image of itself whether you include Amazon in the sample or not. But we should also keep in mind that while AMZN growth is impressive, its annualized revenues are at around $90bn compared to almost a $1trln for all other US retailers. And its net income is still basically zero, compared to $30bn earned by its bricks-and-mortar competitors. The graph in Figure 3 is showing the total return relative performance of US consumer staples equities 1 and consumer discretionary stocks2, and it shows the latter underperforming to the tune of 16% from the highs reached in March of this year. Four-fifths of that underperformance materialized in the last two months alone. The only two times have seen this pair moving to similar or greater extents over the past twenty years were in Mar-Nov 2000 and May-Nov 2007.
These three indicators require our continued monitoring going forward given their track records and present day levels.
The hardest questions we are trying to reconcile here are how is that possible to see all these signs of weakness under the surface – including weak commodities, tightening credit, retrenching consumer spending – being balanced by very strong equity markets and upbeat employment picture.
One of these sides has to be wrong in its assessment of the current macro environment, and seeing both of them extending well into the future appears unlikely to us.
