Macro Prophet — Ones and zeros

Dan Alderson

17 January 2024•8 min read

“We are all living, at most, half of a life, she thought. There was the life you lived, which consisted of the choices you made. And then, there was the other life, the one that was the things you hadn’t chosen.”

Only halfway through January and already the outlook for 2024 looks incredibly binary for credit risk. One could easily determine that potential sources of idiosyncratic risk are accumulating — be it company or sector-specific debt worries, global geopolitical flashpoints, or the good old US election trail. But there is also scope for systemic risk to hit everything — should central banks provoke a market tantrum, or geopolitical flashpoints escalate into all-out war.

This undecided, deeply uncertain array of possibilities put me in mind of Gabrielle Zevin’s gamer novel 'Tomorrow and Tomorrow and Tomorrow'. It’s a beautiful but heart-wrenching rollercoaster that up-ends expectations from start to finish — a fitting airport read as we fly into the year.

Within leveraged credit, a lot of investors are still eyeing up further compression of spreads in 2024 rather than the reverse. This is fuelled in part by the technical aspects of an undersupply of paper as well as inflows to funds. George Curtis, portfolio manager at TwentyFour Asset Management, wrote in a Monday blog post of money being used in a ‘grab for beta’:

“For example, CCC bonds saw double the spread move tighter last week compared to the index (while still leaving the average CCC rated credit at 1000+bps), with sectors that underperformed last year (like real estate investment trusts) significantly outperforming this year,” he wrote. “With BB spreads that are in the ~20th percentile post-GFC, we can see this compression continuing to play out in the coming months, although if flows turn weaker (or net supply beats expectations) that might be a bearish compression (i.e. BB selling off) rather than a bullish one.”

Regardless of whether the bullish compression thesis is merited, I’d agree that most focus so far this year is on broadly market-directional themes rather than idiosyncratic headlines — single name fallout such as that seen around Spanish firm Grifols in recent days are the exception rather than regular daily business. I just think the market has misunderstood or under-evaluated some of those directional themes.

High yield bond defaults have stayed very low, at sub-2% in Europe. Pertinent to our CLO subscribers, there is some evidence of an advance in loan defaults of late, as Bank of America wrote in a recent report:

“The European leveraged loan market has seen a very slight uptick in defaults, with the ELLI 12-month rolling principal-weighted default rate reaching 1.6% now compared to approximately 1.25% in Q3 2023. Among the more recent defaults are cable operator Tele Columbus (which missed a coupon payment in Nov 2023) and elevator manufacturer Wittur (which entered restructuring in Dec 2023).”

A somewhat varied picture has emerged in privately-owned high yield single-Bs and triple-Cs, as BofA’s New York based head of high yield credit strategy Oleg Melentyev illustrated in a recent post. Noting these as a proxy for private credit, he charted a 7.7% default rate in 2023. Excluding distressed debt exchanges, hard defaults were 4.5%.

“Current valuations have improved to 270bps yield premium over public HY for new money entering the private credit segment, providing a good margin of safety going forward,” wrote Melentyev. “Three factors contribute to this premium: private component, smaller-issuer component, and lower quality tilt. These are distributed in a roughly 25/25/50 proportion.”

So that’s idiosyncratic risk.

Systemic risk components on the other hand are advancing rapidly, with the UK/US bombing of Yemen, Iran’s capture of a ship, Houthi attacks on US and Greek commercial carriers, and today (Wednesday) Iran making strikes on Pakistan. China’s response to the Taiwan election result is also something worth keeping a very keen eye on.

Among all of these players, we're missing a voice advocating for de-escalation. It’s not being overly cynical or partisan to recognise that war has historically helped incumbent US and UK governments find public support in times of need. In these times though, the likelihood of opposition parties trying to talk even tougher is, well, YUGE.

This morning, Deutsche Bank’s Jim Reid opined that things are looking a little like the 1960s, when “the Fed cut rates just as fiscal spending rose because of the Vietnam war”. Let’s hope we’re nowhere near another Cuban missile crisis, but it does add another reason for central bank caution.

That feeds into the central question for macro credit this week.

Credit spreads have been widening, with the iTraxx Crossover starting today 10bps wider from Friday’s close at 331bps, but market volatility is still very low, in the broad analysis. Any sources of systemic risk could move the dial rapidly though. Possibly it is just starting to turn, but this has as much to do with something the market has probably got plain wrong in its outlook for the year rather than exogenous geopolitical shocks.

iTraxx/CBOE Europe Crossover one-month volatility index — via S&P

One very obvious macroeconomic feature seems to have confused markets… There are only two months to go till central banks were widely tipped to begin cutting rates, yet there are hardly the conditions in place for them to feel this is necessary.

Why has market pricing been so optimistic about a Fed pivot by March? US growth is hardly falling off a cliff, as the Atlanta Fed predicts the country’s fourth quarter GDP reading to come in around 2.4%. The US rather surprised everyone to the upside with its 4.9% reading, let’s not forget. And S&P 500 earnings look set to register 3-4% growth for the last quarter, hardly calling for an urgent rate cut in two months. The AI-driven tech stock boom has resumed apace, with Nvidia already up another 17% since the start of the year.

That’s why a big evolving feature of Q1 could be markets’ recognition that it’s too early to cut rates unless something really big happens, like a crisis hitting banks, real estate or debt. This looks the case for the ECB as well as the Fed, even though European growth is slow and Germany is struggling to reverse its ailing fortunes. ECB officials have indicated today a rate cut may not happen till June, if at all in 2024.

Today’s surprise rise in UK December CPI to 4%, from 3.9% in November, will not have helped. Eurozone inflation has been heading lower and Eurozone industrial production only registered one (minor) positive reading in the last nine months. But this was the plan for the ECB, which looks more set on winding down pandemic market support programmes rather than leaping to cut rates.

No wonder the euro is giving back some recent gains agains the dollar.

Euro vs US dollar

What if the currency markets have got this directional play right? What would it mean for credit market sentiment if the ECB were to wait till June before pivoting, and only implement four cuts rather than the six widely expected in 2024? I’m sure everyone would take it really calmly and not have any sort of tantrum… just as they didn’t get totally carried away with bullish exuberance around the central bank pivot thesis in December…

Where it would get really messy is if investors have to keep rethinking how the shape of the rates curves will evolve. Should central banks proceed on the timeline markets anticipated going into 2024, then you’d expect dis-inversion of US Treasuries and other government bonds to be the big play of the year. Historically, the two-year point should trade lower than the 10-year.

US Treasury curve as of Wednesday

Yet we already saw plays on an end to that rates inversion — which has existed since July 2022 — come unstuck in recent months.

All of this is under reappraisal as debt primary markets are trying to climb into gear. There’s a fair amount already in progress across loans, bonds, private credit and CLOs, as 9fin has reported on here, here, here, here, and indeed here.

Quite apart from the prospect of it injecting volatility, the rates outlook has big implications for whether bonds or loans are in favour. Expect plenty of timely analysis from 9fin on that very question as more deals emerge.

Certainly the projections for CLO pricing and pipeline look bullish, as Deutsche Bank’s recent appraisal of European spread compression shows:

There’s much up in the air, and much at stake. But at least for credit the market is starting 2024 on what appears to be a good footing. Things look sure to get a lot more volatile at points this year, and maybe quite soon. But with such an array of different drivers, there will also be ample opportunities to be on the right side of trades — as well as on the wrong side.

I’ll leave off with some wisdom from one of the main characters from Zevin’s novel:

“What is a game?" Marx said. "It's tomorrow, and tomorrow, and tomorrow. It's the possibility of infinite rebirth, infinite redemption. The idea that if you keep playing, you could win. No loss is permanent, because nothing is permanent, ever.”