European Financial Credit Sending Worrying Signals

We warned on Friday that the strength in equities was divergent from any of the higher beta risk-on trades and today has seen this divergence grow even larger as European credit markets are selling off considerably even as stocks maintain some semblance of extending-and-pretending. Subordinated financial credit has now retraced over 62% of the rally from 11/25 to 12/7 and XOver (the European high yield credit index) has retraced 50% of that rally. The broad European equity index tracked by Bloomberg has lost significantly less, seemingly ignorant of the stress (EUR-USD basis swap widest in two weeks) as we see even Main (the European investment grade credit index) now starting to drop notably. If, as we have experience cycle after cycle, credit anticipates and equity confirms, then it seems to make sense (especially given the concerted weakness in metals which suggests some kind of margined selling or cash-need desperation) to at worst hedge long equity beta.

The dark-blue line is the BE500, broad European equity index and light blue is the subordinated financial credit spread index. Note the significantly more aggressive derisking of the last 2 days in credit indices relative to stocks (black is XOver - the high yield bond market and red is senior financial credit). Friday saw Main (investment grade credit) hold up - which we noted made sense as up-in-quality rotation made sense (non-financial) - but the index itself contains notable financial exposure and so is being dragged down also now. Beta-adjusted, equities are dramatically divergent from credit's weakness and given the cost of carry on those higher beta credit indices, it appears conviction of a negative perspective is growing. Much as we saw in the US, we suspect Senior-Sub decompression and Main-XOver decompression trades were being laid out and now the broader market is catching up to the risks.

Chart: Bloomberg

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