We have written a lot about using implied volatility as the measure of how equity markets will react to supposedly high risk political events, including Brexit and the US Presidential Election. This week, Institutional Investor has been good enough to publish our article making precisely this point. Today, however, I want to focus on corporate credit and its importance in determining the success of central bank policy.
Once again I am grateful for outside help, in this instance EvergreenGK for pointing out when and why “Don’t fight the Fed” works. The crux of the argument is that our mantra should really be “Don’t fight the Spread“.
The message from implied volatility in equity markets is that stocks and shares are set fair for the next three months at least, which takes us to the eve of the Presidential election, supposedly the most polarising event in living memory. Equity investors are relying on volatility-crushing central bank interventions to maintain an upward trajectory to equity markets.
Evergreen notes that the early 1930s, the start of the 2000s and mid-2008 to early 2009, were all periods of expansionary monetary policy and terrible stock market performance. If you hadn’t fought the Fed on those occasions, your portfolio would have come-a-cropper. The signal to break from orthodoxy was the rise in corporate credit spreads, because investors considered the risk of companies defaulting to be so great that no authority could do anything about it. This proved to be the case for periods of time that we now call the Great Depression, the bursting of the Dot-Com Bubble and the Global Financial Crisis.
So to today and the five-year credit default swap for the average large cap US company as an indicator of risk for equities. The low point of the median CDS was June 2014 and there has been a steady rise since April 2015. This coincides with total global trade by volume (not value) starting its decline; hard evidence that the trend towards globalisation ended well before protectionists were the only choice for the White House.
I have shown the chart over a five year period. What this highlights is that corporate credit risk is now very close to the average level over that period and below levels seen in 2011 (thus well below extremes three years earlier). The high point of central bank potency has passed, because the links between money and trade, a primary conduit of long-term global growth, are just too tenuous. What central banks appear to have done however, thanks to the ECB’s intervention in February, is cap the level of risk for now.
The trends for large European corporate credit are similar to those in the US. Average credit costs are 13% higher in Europe, despite US policy rates being above those in Europe. This means that the risk of companies defaulting is greater than in the US, even though the ECB has been buying corporate debt directly since June.
This week the Bank of England announced that it would purchase up to £10bn of corporate debt. The rationale for this is that it will do more to make investors buy other corporate securities (i.e. equities) than if the Bank simply purchased more gilts. Also, with the cost of debt reduced, companies should issue more debt. It remains to be seen whether this has any impact on corporate investment, but recent history suggests that it will boost share buybacks and M&A.
Credit risk in the UK is higher than both the US and Europe. The highest risk is for mining companies, followed by supermarkets and then financial companies. The issues with each of these industries pre-dates Brexit by some way, although as we argue in the Institutional Investor article, the rapid response to Brexit by the Bank of England will only exacerbate the woes of banks and insurers. The UK economy is peculiarly dependent on financial industries.
The success of central banks in holding down corporate credit costs may well determine whether you should be “fighting the Fed” or going with the flow. OTAS presentation of corporate credit is relevant because of the deep statistical analysis that sits behind every chart and table and in the flags that alert you, stock-by-stock, to significant credit events. You can stare at other screens for hours if your firm buys the data feeds, but without the statistical significance, it’s all just noise.