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Two articles published overnight indicate that the period of central bank omnipotence has ended. The Daily Telegraph carries this commentary on the ECB exhausting its ability to improve the Eurozone economy and this piece about the need for central banks to continue to project omnipotence, whatever the reality. One of our favourite analysts, Ben Hunt, has already declared  that central banking influence is on the wane.

Our recent blog on the logic of investors doubling up equity positions through the option market concluded that this strategy was rational when central banks are the primary influence over stock markets. It stands to reason that if this influence is on the wane, then the risks to equity exposure are mounting.

At OTAS we spend a lot of time looking at the indicators that may inform investors about a change in trend. One popular indicator is the level of credit default swaps, shown here for the median US large cap.

US Large Cap Median CDS

US Large Cap Median CDS

The lowest level of risk for US companies on this measure was June 2014. We have noted that this corresponded to the approximate peak in global export volumes and that economic momentum has deteriorated subsequently. The Fed indicated its taper strategy in December 2013 and officially ended bond buying in October 2014, but it was not until April 2015 that the cost of credit for US corporates began a meaningful rise. Credit risk has returned to its average level and stalled. This may indicate a reluctance to believe that the Fed can raise interest rates meaningfully.

US Large Cap Median Implied Volatility

US Large Cap Median Implied Volatility

Implied volatility is another favoured measure of risk. This also reached a trough in the summer of 2014 and showed a more meaningful pick up from Q2 2015. The reduction in implied volatility since February however, is at odds with the CDS risk indicator. This may suggest that the actions of investors are supressing volatility without the same degree of support from central banks as in the past. This is either because corporate earnings are on a growth trajectory, or because a bubble is forming based on past behaviour by central banks.

US Large Cap Median PE

US Large Cap Median PE

The PE valuation of US large caps is above its average range and on the verge of completing four weeks of decline from close to record highs this cycle. PE can fall due to rising earnings or falling prices and there is nothing to stop the two occurring simultaneously.

The situation in Europe sees the PE valuation of large caps at the very top of the average range. Relative to US stocks the valuation is mid-range, as shown below. The relative valuation has been rising since early July, which may be currency related. It does not, however, bear out relative rates of growth and is not factoring in that further ECB action may be detrimental to the economy, as suggested in the first article referred to above.

European Large Cap Median PE relative to US Large Cap

European Large Cap Median PE relative to US Large Cap

Our final chart shows the valuation of large cap UK stocks. This looks a lot like the US chart, albeit at slightly lower levels of PE. Short term positive EPS revisions are dominated by the Materials sector; much as Energy stocks dominate the list of most recently upgraded US shares. In Europe, ex the UK, without such a prominent resources sector, upgrades show no obvious sector bias.

UK Large Cap Median PE

UK Large Cap Median PE

The last month suggests that cracks are beginning to form in the equity bull market thesis. One rationale for this is that the power of central banks to influence stock prices is diminishing, perhaps at an accelerating rate. The bigger point is that monetary policy alone has been insufficient to drive an economic recovery that translates into corporate earnings rising as quickly as stock prices. One has to doubt that investors will afford politicians and fiscal policy the same perceived omnipotence as they have allowed central banks and monetary policy in recent years.

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.

Average 5Y CDS for US Large Caps

Average 5Y CDS for US Large Caps

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.

EUR CDS

Average 5Y CDS for European Large Caps

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.

UK CDS

Average 5Y CDS for UK Large Caps

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.

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute – William Feather

The media is alive with lurid stories of volatility back at seven year highs. This refers to foreign exchange volatility and it is hardly surprising, as central banks have done their level best to dampen volatility for seven years, but everyone knew that this would last only as long as market participants chose to believe. If Brexit is indeed the reason why currency markets are aquiver, then this should be no surprise as the campaign for the UK to leave the EU has risen in defiance of central bank warnings, along with those of the rest of the establishment.

Back in April we published a post arguing that there was no evidence of Brexit related volatility in equity markets. OTAS implied volatility (risk) analysis centres on three-month single stock options and so April was already discounting expectations for the post referendum period. The prevailing consensus, however, may well have been that there was no way that the UK would vote to leave, and it is this consensus that is being shaken with reports of nine out of ten recent bets placed with bookmakers anticipating Brexit.

UK Shares Average Implied Volatility - Short Term

UK volatility, whereby options investors expect a +/- 16% move in share prices in three months, is at the top end of its two year range. This is +/- 1.5% more uncertainty than in April. Today’s level, however, remains below the peak in February, when it is worth remembering that the prevailing panic was about global growth, not politics. Last night US bond spreads were at nine year lows, which is a recession warning, and it would be a stretch to blame Brexit for concerns over domestic US economic growth.

UK Shares Average Implied Volaility - Long Term

It is also worth viewing UK equity volatility in a longer historical context. Compared with previous peaks in 2011 and 2008, the recent increase in uncertainty barely registers and remains well within normal bounds. Even during February’s market fall, when the prevailing wisdom was that there would be a recession this year and not one triggered by UK voters, uncertainty did not rise beyond the normal range. Investors should keep an eye on this measure over the next eight days to judge how far the Brexit hysteria spreads.

UK Company Aveage P/E - Short Term

UK average P/E valuation has fallen back into the normal two-year range, having reached a peak in mid-April. The valuation has moved, swung would be too aggressive a description, between 14x and 17x over the last two years and could fall another 8% before reaching that lower valuation. The drop since mid-April has been 10%.

A look at earnings also suggests that there is little to be overly concerned about in the world of equities. Analysts have been downgrading UK shares more often than upgrading for the last six months, but the ratio of downgrades to upgrades has fallen recently.

 Average UK Share

Upgrades over 1%

Downgrades more than 1%

Last 6 months

33%

59%

Last 3 months

30%

39%

Last 1 month

13%

18%

Source: OTAS

While it would be convenient to blame economic uncertainty caused by potential Brexit for the downgrades to earnings expectations, if this were the main reason for changes, then the downgrades would surely intensify as a leave vote became more probable. The opposite is true. We do well to remember that analysts almost always start a year more positively than they finish it, as reality bites into bonus-period optimism. Analysts are also notorious for not changing their estimates until guided to do so, thus there is a reasonable chance that company executives would use the cover of a leave vote to downgrade their outlook, whatever the underlying reason for caution.

With even Mark Carney admitting that the Chinese debt mountain is a greater concern than Brexit, there are plenty of excuses for corporate chieftains to cut themselves a little slack. Keep an eye on the OTAS measure of implied volatility for an early steer as to when this becomes a cliff edge issue, rather than the gentle undulation that it is at present.

The striking thing about European equity markets is how stable they are right now. EPS Momentum is mildly negative in most major markets, valuations are very similar and implied volatility is as expected, with Switzerland deemed least risky and Spain the most. More importantly, the country markets are trading relative to each other precisely as you would expect.

So where is the Brexit risk, the great fear that the UK will dive off a cliff should the population defy the European elites and vote to quit the European Union (note to editors, the UK would not be leaving Europe, which is not possible geographically). Equally, where is the fear that a UK exit after the June 23rd vote will lead to a tailspin for European markets. Answer; there isn’t any.

In OTAS we track three month implied volatility more than any other duration. We do this because there is plenty of liquidity at this point relative to at other times. As of April 11, we are less than three months from the UK vote and hence today’s numbers reflect perceptions about where markets will trade on the other side of the decision.

The strongest evidence of a Brexit effect

The strongest evidence of a Brexit effect

The chart above represents the strongest evidence of a Brexit effect, in that implied volatility (read uncertainty) for leading UK shares is slightly above the average range over the past two years relative to France. This, however, is a relative rating, and the implied volatility of the two markets is very similar. Option traders expect UK stocks to be +/-14% by July 8 and French ones to be +/-14.5%. So uncertainty is marginally greater in France.

Over the same time, traders expect Spanish stocks will be +/-18%, Italian +/-17%, German +/-13% and Swiss +/-11%. This is how these markets line up next to one another most of the time, except when there are perceived problems on the horizon. What is more, the current level of volatility is in the average range of the last two years, having been much higher in February, before the date of the UK vote was announced.

Uncertainty in France is in the normal range

Uncertainty in France is in the normal range

Stock market valuations are normal as well, safely in the average range, where you would expect relative to one another and at very similar levels. France, Italy and Spain trade on 15x 12 months’ forward earnings, the UK on 16x alongside Switzerland, and Germany on its typical slightly lower rating of 14x due to the composition of its more cyclical stock market. The UK has re-rated relative to Europe so far this year and not because EPS Momentum has fallen relative to elsewhere. If anything, the UK market is looking toppy.

The inverse Brexit effect

The inverse Brexit effect

What is behind the complete absence of Brexit panic in stock markets? One answer is concerted and coordinated central bank action to crush volatility. Another is that the world has bigger problems, in terms of an economic slowdown precipitated by nearly two years of falling global trade volumes, than the possible changes in an inward-looking Europe. A third is that those people who put money on these matters, day-in, day-out, do not think that anything very much will change whether the UK is in the EU, or votes to leave.