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Secular Stagnation and Earnings Crises

The bad news. Credit spreads are predicting a recession for 2016. Not much better for credit, late 2015 they were processing the unappealing likelihood of future Fed rate hikes in 2016.

The good news. You can’t have both.

In either case, credit has a lot of value restored in North American high yield and it is obvious to even those living under a rock why this is the case. The cash flow impairments due to historically cheap oil. As spreads in energy went up, spreads in other sectors moved in sympathy with them. As energy default rates go up, default rates in other sectors won’t.

Look at swap spreads for a liquid measure of this sympathetic response. Energy names constitute 15% of the US high yield market. Not so XO in Europe or investment grade EM debt. A little over a year ago they traded very, very tight. Because of energy names in the North American (NA HY) index, the other trade rich to it.

According to Goldman Sachs, US cash bonds of high yield oil explorers and producers have yields so high that the sector could withstand defaults of 85% and still breakeven. I would say that this builds in a very plain-vanilla view on recovery prospects, which is not warranted given recent recoveries. Yet the point is clear as to how stressed the sector is. The current broader market dislocations create opportunities to add further yield and pick up capital gains down the road.

Regarding the broader high yield market, the age-old problem is that people don’t want to jump in early and take mark to market losses prior to the eventual sharp rebound. So they wait. This time, the wait for a rebound could be a long one. The cash index is at elevated levels, with CDS moving with it noting the index roll effect. Finally, XO is at rich as it has been in 15 months.

It chalks up to an erosion of investor confidence, which is a necessary ingredient to any rally. The new breed has to get used to a new era of persistent volatility in fixed income. Banks now very low inventories of corporate credit compared to the past. There is no way to avoid bigger price swings than what was seen in the known precedents. Get used to it or get out.

Recent economic data indicates that the economic slowdown is an earnings issue (outside of energy and mining sectors) and not a solvency issue. US household debt has fallen from 134% of income in 2007 to 105% in mid-2015. Even if this makes spending anemic, cheap gas only speeds up the delivering process to its final end. Regarding financial contagion, NA HY energy names constitute 15% of cash bonds, but only 2% of the US loan market. Contagion risk through the banking system is low.

Further, uncertainty around the Fed’s interest rate policy and the somewhat interconnected protracted the commodity and energy price declines are making a toxic combination for risky credit with or without recession.

This is why a recession, should it occur, will be met with further easing, likely even extraordinary measures like QE. History shows that the requirement is a market that feels sufficient pain and shaken investor confidence.

In the last five years this is the essential logic of investing given secular stagnation. Time and time again capital markets reflecting poor confidence bet big against the success of local monetary authorities. There was a bet against the US financial system, to which the Fed responded. Then it was a sovereign debt crisis in the EU periphery. Now we are faced with an epic debt run-up and a resulting deleveraging that is driving a hard landing in China. Since the Chinese state is the largest shareholder of the Chinese financial system, its ability to stave off a liquidity crisis effectively limitless. The global economy flipped in and out of recession for a decade during the Great Depression and Treasury yields and credit spreads stayed below historical levels.

No recession? US high yield credit will be tighter by Q4 2016, offering enhanced yield and capital appreciation.

Recession? US high yield credit will be tighter by Q4 2016, offering enhanced yield and capital appreciation.

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