A curious divergence has emerged within the analyst ranks at JPMorgan, where on one hand there are the bulls such as cross-asset and quant heads, John Normand and Marko Kolanovic, and equity strategists like Mislav Matejka, all of whom are urging clients to remain bullish and carry on buying stocks while ignoring the recent turbulence in the market; on the other hand there are the lone quasi-bears like Nikolaos Panigirtzoglou who writes one of the bank's most popular weekly reports, Flows and Liquidity, and who has a habit of going against JPM's optimistic so-called "house view."
In an ironic twist, Panigirtzoglou's less than "rose-colored" takes on the market come at a time when Marko Kolanovic recently lashed out at anything that is less that ragingly bullish as "fake news", and not just fake but having a greater impact on the market than JPMorgan's own official research, to wit:
There are specialized websites that mass produce a mix of real and fake news. Often these outlets will present somewhat credible but distorted coverage of sell-side financial research, mixed with geopolitical news, while tolerating hate speech in their website commentary section. If we add to this an increased number of algorithms that trade based on posts and headlines, the impact on price action and investor psychology can be significant.
Amusingly, and perhaps to front-run attacks on his own research, just hours after Kolanovic published the above "hot take" (which came as he was again calling for JPM clients to "buy the dip", and ahead of the market's latest rout), Panigirtzoglou wrote the following disclaimer in his latest weekly report:
As a note to our readers, the above analysis does not represent JPM’s official views/forecasts about US share buybacks. These JPM official forecasts are more positive and are outlined in the reports by our US equity strategists (Dubravko Lakos-Bujas and team). Instead, the objective of our analysis is to highlight risks around the house view.
In other words, JPM's bearish takes are not "fake news" - they are just meant to provide cover when the house's "more positive" forecasts for popular consumption - end up being wildly wrong (that, and to tell the more "perceptive" clients what JPM really thinks).
Not surprisingly, we find Panigirtzoglou's "less positive" if more accurate and thought-out research reports far more informative than the "more positive" JPMorgan "official view", which in turn brings us to his latest weekly note which this time takes on the topic of rising downgrade risk within the high grade sector, a topic near and dear to us as just yesterday we pointed out that in the fourth quarter alone, some $176 billion in A-rated debt was downgraded into BBB territory according to Goldman calculations, "the highest amount since 4Q2015, which was a period characterized by a heavy wave of commodity-related "fallen angels."
The reason why Panigirtzoglou is also focused on the sensitive topic of fallen angel downgrades, is because as he explains with the credit cycle turning (and entering a bear market according to Morgan Stanley) and High Grade credit spreads making new highs in both the US and Europe (where spreads are now at the same level they were when Draghi launched QE back in 2016)...
... "one of the issues credit investors are facing is that of rating downgrades and fallen angels, i.e. corporate bonds downgraded
from investment-grade status." This, as the JPM strategist explains, is not because rating downgrades or fallen angels have forecasting ability in terms of gauging the direction of the credit cycle - on the contrary they tend to rather lag the credit cycle - but they are important in gauging the negative impact on credit returns: This, as we have explained previously, is because rating downgrades or fallen angels "drive a wedge between spread returns and total returns as the managers who are only allowed to hold investment grade bonds are forced to offload their downgraded bonds."
So how big are the rating downgrade or fallen angel effects? The good news, is that at the moment, the answer is "pretty small." In fact, these rating downgrade or fallen angel effects have barely started because, as the chart below shows, the number of fallen angels in JPMorgan’s global high yield dollar denominated index still stands at very low levels typically seen at the beginning of a credit cycle (this is a far lower number than the abovementioned surge in downgrades from A to BBB, or credits which can be dubbed pre-fallen angels).
A quick look at rating downgrades reveals a similar picture because like with fallen angels, corporate downgrade reviews have yet to rise materially.
As a result, while many have expressed concern about the threat from future downgrades, the realized negative impact that downgrades and fallen angels typically exert on credit returns has yet to hurt credit investors in a big way.
So are current concerns by traders and market participants about rating downgrades/fallen angels justified?
This is where the abovementioned internal dichotomy in JPM's views would emerge, because while we would expect Kolanovic to respond firmly in the negative, Panigirtzoglou believes the answer is yes if one simply looks at credit fundamentals such as debt-to-income ratios. In fact, as the JPM strategist writes, "a visual inspection of debt-to-income ratios across the universe of companies behind corporate bond indices reveals a highly problematic picture."
The four charts below show the net debt-to-EBITDA ratio for companies behind JPMorgan’s HG and HY indices in both the US and
Europe. Panigirtzoglou warns that the leverage metric has been rising steeply over the past decade to levels that are much higher than those seen at the peaks of the previous two cycles in 2007/2008 and 2001/2002.
In other words "companies are currently much more vulnerable to a decline in incomes and/or rise in interest rates that in the previous two cycles."
This is especially true in the US where the Fed hikes coupled with its balance sheet shrinkage have pushed corporate bond yields close to the 5% mark, creating vulnerability for credit in a risk scenario where earnings contract next year. In Europe, a similar demand/supply balance problem looms for corporate bonds next year when the ECB ends its corporate bond program on Jan 1.
Narrowing the observations down to just BBB companies, which currently account for more than half of the HG corporate bond universe, look equally vulnerable.
As laid out in the two charts below, the median net debt-to-EBITDA ratio for companies in JPMorgan’s BBB indices in both the US and Europe has also risen for BBB corporates to above the peaks of the previous two cycles especially in Europe. More importantly if one looks at the portion of BBB companies with net-debt-to-EBITDA ratio higher than the BB average of 2.3 in the US and 2.6 in Europe since 2001, JPM finds that this portion stands at 55% currently in both the US and Europe, or at the highest level in at least two decades.
At face value, from a net-debt-to-EBITDA point of view - and much more concerning from a future downgrade standpoint - more than half of BBB companies in the US and Europe look more like high yield than high grade.
And this is why to Panigirtzoglou this suggests that "the downgrade and fallen angel risks look pretty elevated at the moment for both US and European high grade corporates, raising the prospect of disorderly transfer of risk between HG and HY markets over the coming year."
This is a problem because as Bank of America first pointed out back in June, in Europe alone JPM estimates that roughly €100 – 120bn of bonds could be downgraded from investment grade to high yield during the next recession. This would cause the Euro high yield market to balloon in size by at least a third from the current notional of just over €300bn.
In October, Morgan Stanley applied a similar calculation to corporate bonds in the US, and found that over $1 trillion in IG bonds could be downgraded to High Yield once the cycle turns.
Summarizing the above, Panigirtzoglou concludes the because of these capacity problems, a "disorderly transfer of risk" between HG and HY markets is an increasingly greater threat to the credit market (which already has its hands full with the sudden repricing and turmoil sweeping across the leveraged loan market). Or, as Kolanovic would say "fake news."