risk

All posts tagged risk

The oil price has been a primary focus this year with three main schools of thought about its importance and impact on markets. The first sees falling prices as a negative for equities, because falls reflect weakening demand for commodities as a result of a coordinated global slowdown in economic growth. The second views energy prices as a quasi-tax and expects stronger economic growth as a result of price falls, with the overall impact on equities beneficial despite the carnage in the energy and basic materials sectors. The third school sees most things as a function of excessive global debt, exacerbated by central bank policy and treats an oil price fall as a consequence of the inevitable over-capacity that results from mispricing credit.

Whichever camp you are in, OTAS tracks the indicators that foretell of any recovery in equities linked to energy and commodity prices, whether this has to do with suppliers going bust, improving demand or tighter monetary policies (okay, maybe not the last one). The oil producers considered most at risk are the shale field producers of North America, where production costs are high and leverage even higher. The median credit default swap for North American companies is 280 bps (remember European banks are around 105 bps).

NA Energy CDS 2 yr view

Credit risk remains high in the US

Option market implied volatility, a measure of uncertainty, has reduced from a peak five weeks ago, but remains elevated compared to recent history and suggests that the average energy share could rise or fall 25% over the next three months. Investors are asking whether they can afford that volatility, but also whether they can afford to miss out if the sector were to rally so much.

NA Energy IV 2 yr view

One way or another, the shares are going to move

There are some very small stocks impacting the analysis above, but the median large cap stock is still predicted by those with skin in the game to move +/- 20% by mid-June. Companies such as Williams, Continental Resources and Baker Hughes are expected to move at least 50% more than average. Exxon, Chevron and Schlumberger, in contrast, should be relatively sedate.

Short interest provides a third risk indicator for the sector. While short interest is back at the average level of the past two years overall, for the large caps there is a clear upward trajectory, in spite of the recent pullback. This is in keeping with broader market reports, such as CFTC data, that short covering has not been a feature of the recent equity market rise.

NA Energy SI 2 yr view

Short interest is trending upwards year-to-date

In Europe, the risk indicators for Energy are more benign. This is because there are fewer wildcat operations listed and as Europe lacks the deep option, CDS and short interest markets that define the US. Credit risk among Europe’s energy giants is a little over a third of the North American average and barely differentiated from Europe’s banks. Short interest is at relatively low levels and implied volatility suggests stock moves of +/- 15% in the coming three months.

European energy stocks should move around thwo thirds as much as the US

European energy stocks should move around two thirds as much as in the US

All of this suggests that acute problems in the Energy sector are a peculiarly US trait, as a function of the high borrowing and extraction costs of multiple smaller oil producers. Both sectors yield a similar amount at around 4.3% 12 months’ forward, although US large caps promise only 2.8% as a reflection of their haven status within a troubled industry. European energy equity investors are happy to ride out low oil prices, comforted that the income from their holdings is a rare bonus in an environment of ever-lower interest rates.

None of this should provide grounds for complacency and OTAS continues to track individual names to see where risk is hiding. One particularly powerful analytical tool is divergence, a bespoke measure of by how much equity prices are divorced from the other risk indicators of credit, option volatility and short interest. Do you have a holding that is becoming riskier faster than its peer group; contact us to find out.

Within OTAS we use many metrics to keep an eye on risks for equities. Credit default swap (CDS) spreads have been a coincident and occasionally leading indicator of trouble, especially for the bank sector. And when the bank sector is in trouble, the rest of the market tends to follow.

The median CDS of European banks spiked of late. A rise in value happens when debt investors become concerned that their bonds will not be honoured in full, while a fall back indicates that those concerns have eased. The latest reassurance was rapidly forthcoming.

Banks CDS 2 yr view

A quick round-trip for bank risk

It is worth pointing out that risk remains elevated relative to the average level over the past two years. A couple of years ago 100 bps of risk was the point at which we might start worrying about corporate credit, but in a world of zero and negative interest rates, 100 bps seems pretty high (I’d like it on my savings account please, Mr. Banker). The risk however, remains well below the peak of nearly 350 bps reached in 2011 and was put back in the box pretty quickly over the past two weeks.

Once again the ECB rode to the rescue, with another promise of saving the financial system (read the Euro and the politicians whose entire careers depend on it), with what once was quaintly referred to as unconventional monetary policy. Of course, for prices of CDS to fall as they have done in the last couple of weeks, someone has to become much less risk averse. That someone is anticipating unloading all unwanted bonds onto the ECB at sometime between now and expiry.

The consequence of a central bank buying corporate debt is that corporate debt no longer carries the same signalling quality for equity investors. It may be that we need to pay much more attention to far smaller moves in the median CDS, for it is by pushing up the price that investors signal they need another intervention from the ECB. These investors are hungry offspring, nuzzling mother, until she rolls over to uncover her teat.

There remain other measures of risk. Short interest is one that has had mixed benefits, because the authorities are prone to interfere in this market pretty rapidly. The steady rise in short interest on the average European bank year-to-date however, would appear to be sending a message.

Banks SI 2 yr view

Short sellers home in on banks

It is noteworthy that Nordic banks are among the most shorted names listed in OTAS, with the highest days-to-cover and loan fees.

A third measure of risk is the implied volatility in the options market. This both follows the underlying move and is an indicator of by how much investors believe shares could move. Within OTAS, we measure this over the upcoming three months.

Banks IV 2 yr view

Rising volatility indicates greater uncertainty

Option volatility is a measure of uncertainty about the future. You should pay a higher price for something that you are more sure about, which is why the favourite in a horse race has the lowest odds. Low implied volatility typically suggests that investors believe the good times will keep rolling.

Investors predict, using money not words, that the average bank will move in a range of over 36% by mid-June. This is either up or down by more than 18%. Follow the CDS and short interest for European banks within OTAS  in order to gain a better understanding of whether investors believe that move will be up or down.

OTAS also provides in depth analysis of risks for individual equities, as well as easy to access summaries of sectors and markets, which highlight the individual companies most expected to face difficulties.