UK 5YR CDS via IHS Markit / S&P

Meanwhile the country’s debt to GDP is at a level unseen since the early 1960s and the Bank of England is more comfortable about shocking the market than allowing high inflation to fall further out of whack with the rest of Europe.

The broader worry is that we remain in a phase of ostensibly low market volatility in which nonetheless there are constant sources of panic ready and willing to rear their heads at the slightest provocation. More and more of these trigger points are likely to pop up over the coming months as investors battle their own jitters about holding assets they suspect are overvalued.

Each of these could prove to be a distraction or ‘imaginary malady’ — hence my reference to Moliere’s 1673 play in the title of this edition of Macro Prophet — but they are apt furbishment of the broader theme of deteriorating fundamentals. 

In the play, hypochondriac Argan’s household revolves around his obsession at suffering chronic imaginary illnesses. Under the influence of a pair of unscrupulous doctors, Argan goes as far as trying to marry off his daughter to one of their sons just so he can have a physician in the family. Fortunately Toinette, an insightful maid-servant character (responsible for the quote I cited at the start), is able to repair some of this damage.

Going private

Private credit concerns feel big precisely because this has become such a feverish part of the market — and because it’s private. We spoke last week in the column about how private CLO deals (or some blurring with the traditional BSL CLO format) could soon make up a much bigger component of that market, and this is naturally something many people will see as an opportunity. (We’re also big fans of this market at 9fin, it goes without saying!)

But while loans and bonds have taken a mark-to-market hit of late from public pricing, private credit losses will only become more visible as defaults rise. At that point these more concentrated portfolios of less liquid assets are going to find themselves uncomfortably in the spotlight, particularly if they have favoured smaller companies which historically have tended to suffer higher default rates.

While this points (perhaps hopefully for the traditional CLO / loan community) to an eventual swing back towards public deals, it also means private credit investment over the next year could become more starkly bifurcated into winners and losers. As some lenders feel intensifying pressure, others could lock in double-digit yields on otherwise well performing portfolios with lender-friendly terms.

Long recovery

This bifurcation is also visible across the public credit spectrum. With riskier paper suffering impairments, some CLO managers have taken to buying up long-dated investment grade bonds at deeply discounted levels, with the hope that they can take advantage of the convexity of fixed-rate bonds. 

The notion may feel anathema at a time when one of the big concerns is the number of CLOs leaving their reinvestment periods, but the idea is that many of these will repay much sooner than their stated maturity — particularly if the market turns a corner.

“We see this as a generational opportunity,” the portfolio manager of a very big CLO firm told me. “M&A will inevitably pick up again at some point and drive bonds back towards par. We are not so concerned about the weighted average life aspect and it’s a way to protect investors.”

The converse approach — piling into short-dated higher yielding names — is not without its appeal, particularly if one has concerns about the life-horizon of the CLOs buying them. But this could itself be a misdiagnosis at a time of rising defaults, since those loans arising from LBOs could go through many iterations of creditor on creditor battles. 

This has been happening faster in the US, with recoveries often poor, and raises the question of whether CLO managers truly know their bedfellows in a given deal. To have a chance of curing the patient in that scenario, one needs restructuring experience and a seat at the table. This looks to be a dividing line between managers that is only set to broaden as the cycle turns.

Medical history

“The sick man of Europe” is itself often associated with UK prime minister Harold Wilson in the late 1960s and 1970s. But in truth the phrase has been bandied around Europe much longer than that, as a description of numerous countries. 

It was supposedly coined by Tsar Nicholas I in the mid-19th century to describe the Ottoman Empire — so it’s perhaps fitting that some commentators have again been branding Turkey as such in a week its new central bank team failed to demonstrate much hoped for independence by pulling the punch on an inflation hike to only 15% versus a widely expected 20%.

As with UK metrics, Turkey’s five-year CDS spread is some way off its own recent peak. But it is definitely heading the wrong way as the country grapples with its own inflation and currency woes.

Turkey 5YR CDS, via IHS Markit / S&P

Back on the main ward, the UK’s predicament looks suspiciously like a case of mis-diagnosis. It’s evident the BoE’s shock treatment of a 50bps hike (as opposed to the expected 25bps) came as a result of the latest inflation read coming in higher than expected at 8.7%, with core CPI accelerating to 7.1%. It also recognises that the UK has fallen out of step with the US and Europe, where inflation has been coming down faster than expected.

But while UK private sector wages are rising faster than the US (7.5% overall versus 6%), it is grappling with a much worse shortage of housing supply as well as a greater dependence on mortgage finance with much shorter fixed rate duration than in the US. Add to that the UK’s inflation is driven by supply-side shocks, so the decision to raise rates appears an erroneous policy response that will likely serve to extend the patient’s lapse into recession and stagflation.

“The Sick Man could actually be very good from a trading point of view as we need some volatility,” one veteran credit trader said to me this week. “What we’re seeing now should have been pretty well flagged. It’s unfortunate the BoE is having to do it, but it doesn’t feel like a solution when the issues are on the supply side not demand. There needs to be a better effort to improve supply and correct structural issues on the tax side. What’s clear is that there are now very different credit markets between the Europe, the US and the UK because they are taking different paths on inflation.”

Via ONS

Though the UK has everyone’s attention right now, it’s not clear the ECB is doing a much better job of diagnosis — given its strident view that a course of continuous hiking is required to regulate inflation. Data out this week would suggest it might in fact be killing inflation, but can’t see this because of a lag in the numbers it prioritises.

The Euro area flash Purchase Manager Index reading for June brought a big miss for manufacturing and services, with composite PMI at 50.3 — more than two points below general expectation. France and Germany reported the biggest disappointments, with France falling below the 50-threshold between contraction and expansion at 47.3.

Sympathy for the doctor

It would be remiss in this conversation not mention that we commentators are also the ones who are apt to mis-diagnose the market in times of high stakes. Personally I cut my teeth as a credit reporter in the heady days of 2005-2007, when you could ask a high yield credit trader about the precipitous drop of the ABX Home Equity index and would typically draw a response such as, “I don’t know much about that, it’s not my market.” Exasperation was sometimes barely concealed. Not many market participants saw a correlation.

And when, on 14 February, 2007, I at my former employer Creditflux drew people’s attention to the Valentine’s Day Massacre in TABX (the ill-fated launch of ABX HE index tranches), otherwise habitual doom-mongers passed off “isolated squalls” in ABX tranches as something that could be easily absorbed by an overall system awash with liquidity.

As such it feels an apt juncture to raise a salute to Matt King, global credit strategist at Citi for almost 20 years, who this week revealed he is leaving the bank. The highlight of my dealings with Matt pre-crisis was when he told a standing-room-only loans conference in London that what they thought were triple-A investments in CDOs were only the top slice of a steaming pile of crap in a structure that was actually a CDO-squared (the underlying ABS being in fact securitisations themselves of worthless subprime mortgages). I’ve never witnessed before or since the gasps and looks of horror around the room as realisation dawned.

Matt also described investing in CDOs colourfully in terms of Roman soldiers entering battle in a piece entitled “Veni vidi investivi”, after his original title “How not to get blown up” was apparently turned down by the legal department. “Are the brokers broken?” was another popular if controversial work he put before us.

Now feels exactly the kind of time when someone with Matt’s unique and highly insightful perspective on market folly should be part of the medical examination.

As for Moliere, his play ends very ambiguously on the fate of its main character. Sometimes he survives and becomes a doctor, whereas sometimes… he doesn’t. Moliere himself died on stage while playing the lead role. Let’s hope the UK has a more decisive recovery.

Source: Imgur.com