NEW$ & VIEW$ (18 DECEMBER 2015): YIELDING TO HIGH YIELD

Conference Board Leading Economic Index: Slight Increase in November

The Conference Board Leading Economic Index® (LEI) for the U.S. increased 0.4 percent in November to 124.6 (2010 = 100), following a 0.6 percent increase in October, and no change in September. [Full notes in PDF]

No recession in sight based on the 6-m rate of change…

…and on the leading/coincident ratio:

(Bespoke Investment)

China Beige Book Shows ‘Disturbing’ Economic Deterioration

China’s economic conditions deteriorated across the board in the fourth quarter, according to a private survey from a New York-based research group that contrasted with recent official indicators that signaled some stabilization in the country’s slowdown.

National sales revenue, volumes, output, prices, profits, hiring, borrowing, and capital expenditure were all weaker than the prior three months, according to the fourth-quarter China Beige Book, published by CBB International. The indicator is modeled on the survey compiled by the Federal Reserve on the U.S. economy, and was first published in 2012. (…)

The Beige Book’s profit reading is “particularly disturbing,” with the share of firms reporting earnings gains slipping to the lowest level recorded, CBB President Leland Miller wrote in the release. While retail and real estate held up reasonably well, manufacturing and services performed poorly, with revenues, employment, capital expenditure and profits weakening.

The survey shows “pervasive weakness,” Miller wrote in the report. “The popular rush to find a successful manufacturing-to-services transition will have to be put on hold for a bit. Only the part about struggling manufacturing held true.” (…)

In contrast to the gloomy Beige Book report, data Friday showed China’s home-price recovery spread to more smaller cities in November, after Chinese authorities rolled out easing measures targeting regions with a surplus of unsold homes. New-home prices increased in 33 cities among the 70 cities tracked by the government, compared with 27 in October, the National Bureau of Statistics said.

The Beige Book report was based on surveys of more than 2,100 firms across China and interviews with bankers, managers and executives. CBB began the series in mid-2012, when its inaugural survey indicated a pick-up in growth from early that year, a forecast later borne out.

Geographically, the three most high-profile regions performed the worst, with Shanghai’s “dismal” showing outpacing Guangdong’s and Beijing’s. Every region weakened on-quarter except for the Center and West, the report showed.

“More concerning than overall growth weakness was degradation of two components of the economy that were previously overlooked as sources of strength: the labor market and the impact of inflation,” Miller wrote. Given growth in input prices and sales prices slipped to record-lows while firm performance metrics fell, “it looked like firms were encountering genuinely harmful deflation,” he wrote.

If labor market weakness persists, policy makers in Beijing will feel “increasing pressure” to ramp up the policy response, according to the report.

With official indicators picking up in November, Bloomberg’s monthly China gross domestic product tracker rose to a 6.85 percent estimated growth pace for the month, the best reading since June. Shares have rebounded, with the Shanghai Composite Index climbing 4.2 percent this week. The benchmark equity gauge has rallied 22 percent since tumbling to the low of the year in August.

In a worrying sign for the effectiveness of monetary easing to date, the share of companies borrowing declined to a record low, the survey showed.

“The interest of firms in both borrowing and spending continues to decline, suggesting it’s past time the ‘stimulus mafia’ rethinks its Pavlovian responses,” Miller wrote. “Reform or bust.”

Fed rate rise is first step to rebalance US financial system Yellen will need skill and luck to handle present distortions without sparking another crisis

(…) For a different perspective on the challenge facing the Fed, it is worth looking at another corner of Washington: the Office of Financial Research. Just before the Fed announcement, the OFR published its first Financial Stability Report on the health of US finance. (…)

In finance, there are at least three areas investors need to watch. The first is the fact that the ultra-loose policy has created credit bubbles that could now deflate. (…) debt has increased significantly since 2008 in emerging markets.

Also, the OFR observed this week: “In our assessment, credit risk in the US non-financial business sector is elevated and rising” — to a point where “higher base rates may create refinancing risks . . . and potentially precipitate a broader default cycle”. Thankfully, banks seem fairly well placed to absorb losses. But an outbreak of defaults could spark contagion and market volatility, particularly since post-crisis regulations mean banks are less willing to be market makers in the non-business sector — standing ready to buy or sell when investors want to trade — making it harder to trade the instruments in question.

A second area to watch is the state of American investors’ portfolios. In recent years, asset managers have tried to chase yield by buying longer-term assets with more credit risk. This has now raised the “duration” of bond portfolios — or their vulnerability to higher rates — to historic highs. Indeed, the OFR calculates that a mere 100bp rise in long-term US rates could generate unhedged losses of $214bn for US-based bond mutual funds and exchange traded funds. Once again, the system as a whole could probably absorb such a blow; but it could also spark contagion, particularly since banks, too, have increased their duration profiles.

A third area of concern is that in recent years there have been stealthy shifts in the opaque world of money markets. Before the crisis many asset managers, companies and banks placed spare cash in money-market instruments. Recently, however, this money has flooded on to the balance sheet of banks and the Fed itself. This has made it much harder for the Fed to control the price of money with its usual policy tools.

Another consequence of these little-noticed flows in the money markets might cause a Fed rise to spark further upheaval. Zoltan Pozsar, an analyst at Credit Suisse, thinks hundreds of billions of dollars could soon move back from banks to money market funds — with potentially destabilising consequences that the Fed (and others) are scrambling to understand. (…)

Withdrawals hit US corporate bond funds Market shows cracks as investors pull record $5.1bn from high-grade funds

Investment grade bond funds in the US have been hit with a record wave of redemptions, a week after two high-yield funds announced they would shutter and another barred withdrawals as the credit market showed further cracks.

Investors withdrew $5.1bn from US mutual funds and exchange traded funds purchasing investment grade bonds — those rated triple B minus or higher by one of the major rating agencies — in the latest week, according to fund flows tracked by Lipper.

The figures, the largest since Lipper began tracking flows in 1992, accompanied another week of $3bn-plus withdrawals from junk bond funds.

Lipper put the total investor withdrawals from taxable bond funds in the week to December 16 at $15.4bn. (…)

Leverage has risen rapidly over the past five years as US companies issued debt to fund acquisitions, raise dividends and buy back stock. While banks have largely repaired their balance sheets since the financial crisis, the corporate debt burden in the US has climbed to $5.6tn, up 59 per cent from December 2010, according to Barclays Indices. (…)

HIGH YIELD MARKET: The best analysis from Moody’s:

• Wide Spreads May Block Future Rate Hikes

(…) Never before in the modern era of the speculative-grade has bond market had the Fed hiked rates when the high-yield bond spread was wider than 625 bp.

Going forward, if the high-yield spread remains wider than 650 bp, the Fed may opt not to hike rates at the March 2016 meeting of the FOMC. Moreover, if the spread averages more than 700 bp during the next three months, a weakening of credit conditions may force the Fed to reconsider its current strategy.

Moreover, current outlooks for defaults and profits weaken the case in favor of a percentage point climb by fed funds over the next 12 months. Following the recessions of 2001 and 1990-1991, the Fed began to hike rates in June 2004 and February 1994. The latter two starts to a series of Fed rate hikes were accompanied by declining trends for the high-yield default rate and lively profits growth.

After dipping by a prospective -0.2% annually in 2015, the Blue Chip consensus projects a below-trend 4% rebound by 2016’s pretax profits from current production. An acceleration of labor costs vis-a-vis business sales may squeeze margins considerably in 2016.

The sharp ascent by the average EDF (expected default frequency) metric of US/Canadian below-investment-grade companies from December 2014’s 3.2% to a recent 6.7% highlights the worsened outlook for high-yield defaults.

Nevertheless, a fast rising high-yield EDF metric does not necessarily rule out another Fed rate hike. For example, fed funds was lifted from May 1999’s 4.75% to May 2000’s 6.50% notwithstanding an ominously elevated average high-yield EDF metric of 7.9%, whose then rising trend could be inferred from its average yearly increase of a full percentage point. However, it should be added that by January 2001 the Fed was forced to quickly slash fed funds to 5.5%. Yet the latter was not enough to prevent March 2001’s arrival of a recession.

But this time the Fed may not be indifferent to a worsening default outlook. Today’s macro backdrop compares unfavorably with that of 1999 and early 2000. The 4.5% annual surge by real GDP during the year-ended Q1-2000 towers over the 2.5% growth expected of real GDP for 2015 and 2016.

In addition, the labor market was much tighter according to how payroll employment’s 62.3% share of the working-age population was much greater than the recent 56.7%. Further, unlike the 3.7% year-over-year increase by the average hourly wage for the 12-months-ended March 2000, the average wage now rises by a much slower 2.3%. Thus, it’s doubtful that policymakers will shrug off another extended stay by the high-yield EDF metric of 6.5% or greater. Unless credit conditions improve, the current series of prospective rate hikes may be cut short.

Contrary to conventional wisdom, the yield spreads over Treasuries of investment- and speculative-grade bonds are highly correlated. For a sample beginning with July 1991 and ending in November 2015, the high-yield bond spread shows surprisingly strong correlations with Moody’s long-term industrial company bond yield spreads of 0.93 for Baa-grade bonds and 0.90 for single-A-rated securities.

• High yield woes extend beyond commodities

At this time a year ago, corporate credit risk concerns were largely concentrated around the energy sector. Yet now distress is evident among all commodity related firms, while declines in the value of high yield corporate credit have extended more broadly. The market value of high yield energy and basic material sector debt now trades at 72% of the par value or value at maturity (Figure 5). That is down from last year’s high of 107%, when the steady decline in yields lifted the value of high risk debt. Given that the par value of energy and basic material debt accounts for a hefty 24% of the par value of the overall high yield market in the Barclays index, the travails of these sectors cannot be quarantined from the broader high risk market.

But even excluding these sectors, the rest of the high yield market has also lost a large amount of value. High yield bonds excluding energy and basic materials are now trading at 90% of par value, down from last year’s high of 107%. These stronger performing sectors have lost a combined $59 billion in market value in the past year before accounting for a net increase in the outstanding amount of issuance. With such a large portion of the high yield market in distress, the better performing sectors will not be able to fully rally.

The troubles evident in the high yield commodities sector find a parallel in the credit market bust that occurred in the telecom industry over a decade ago. Booming investment in the telecom sector in the late 1990s helped finance the build out of the nation’s internet infrastructure. This involved a mountain of high yield debt, with the telecom sector accounting for as much as 26% of the US high yield market by 2000. Yet as a wave of failures subsequently flooded the overinvested telecom sector, the rest of the high yield market remained out of favor for several years amid a rising default rate (Figure 6).

After the market value of high yield bonds excluding the telecom sector exceeded 100% of par value during much of 1997, it went on to average 89% over the next five years. During that five-year period ending 2002, the default rate rose from 2.1% to as high as 11.1%. Back in the present, the existence of severely distressed sectors and prospects of a rising default rate are also now obstacles to a recovery in high yield bond valuations.

Adding to the challenges now faced by the high yield bond market is the heavy concentration of issuers at the lowest rating classes. Marking an inexorable multi-decade rise, the share of global high yield issuers rated B3 or lower is 57%, up from 21% from twenty years ago (Figure 7). Issuers at these low levels hold substantial default risk, with annual average historical default rates ranging from 5.2% at B3 to 38.0% for Ca and C rated firms. A once marginal class of borrowers has exploded, with the count of issuers rated B3 or lower, numbering under 100 as recently as 1987, rising to 1,799 at the beginning of 2015. Moderating the risks posed by the low rated skew among high yield borrowers has been the general decline in defaults at specific rating classes over time (Figure 8).

The peak annual default rates during the worst three years of the most recent market downturns for Caa to C rated debt has slid from annual averages of 45% from 1990 to 1992, 28% from 2001 to 2003, and 21% from 2008 to 2010. Yet given that default rates at the riskiest rating categories will not continue to trend to zero, the heavy concentration of low-rated borrowers gives an upward bias to the default rate amid extended market stress. With such a shakeout now underway, the spread on high yield debt will remain above 550 bp throughout 2106, as credit markets continue to point to substantial risks to the business sector and economic outlooks.

YIELDING TO HIGH YIELD

Wednesday’s rally brought the Rule of 20 P/E back to the “20” fair value level. Yesterday’s setback brought it back nearly to its 2-year support level of 19. The “hope” was that valuations would clearly break above 20 like it has in all previous cycles. The high yield market woes coupled with continued low commodity prices and rising probabilities that low oil prices may be with us for a while suggest caution. Going back to 2 stars on my rating.

Hedge funds cut fees to stem client exodus Pressure mounts in crowded sector after another mediocre year