Although my outlook hasn’t been greatly diverted by the latest US jobs numbers or Federal Reserve meeting minutes, the insights I’ve received from investors and strategists have helped identify a few more key things to watch. The roadmaps people are drawing up have a wide array of destinations marked, but their routes to get to these places often intersect.

In any case, the past week’s orderly widening of credit spreads looks to be a healthy response, all things considered. With US Treasury yields having once again hit their pre-SVB levels, the June US CPI numbers due Wednesday (12 July), and a background of China-US trade wrangles, there may be more of that in the coming week.

via JP Morgan Asset Management

The Migration

Some realignment of activity feels due in CLOs as the European CLO market is three-to-four weeks into an issuance pause while the US is open for business. One question is how much can managers really still do before the summer break, but another is whether they have been struggling to get the equity tranches in place. 

Nevertheless, we have earmarked a handful of European deals — including some debuts — that should come through soon, which we will publish early next week as part of our H1 overview / H2 outlook. It will be instructive to see the range of spread tiering between those that do price, how much of a premium new managers pay, and whether there is an obvious shift in portfolios to better quality / short duration loans.

The US faces a slightly different conundrum to Europe. Despite little net new loan issuance to construct portfolios (with non-refi loan business at its lowest ebb since 2009), US broadly syndicated CLO volume reached $44bn in H1, according to Pitchbook data. That’s about two-thirds of where it was this time last year, but still puts things on course for a decent full-year haul.

This resilient dynamic has given a big boost to secondary market loan prices, wrote Pim van Schie, senior portfolio manager at Neuberger Berman, in a note published on Friday. But along with higher CLO debt costs it has been detrimental to the expected return of equity tranches, whose investors are most often the deciding vote on whether and when to issue CLOs.

“CLO managers with captive CLO equity capital have issued based on a range of motivations, from terming out a temporary warehouse financing line to achieving broader business growth and AUM objectives,” he argues. 

“In the second half of the year, CLO managers may become more judicious with their remaining CLO equity capital and increasingly wait for a better expected return environment. This should lead to a slowdown in CLO supply and create a technical tailwind for CLO debt spreads.”

It felt timely in this context that we wrote about CVC Credit Partners holding a final close of CVC CLO Equity III, the firm’s third dedicated CLO equity fund. This closed at its hard cap of $800m, which will be enough to support more than 20 new CLO issuances globally.

My colleague Chris Haffenden also put some thoughts to challenges for CLOs around amend-and-extend and borrower documentation amendments. See his latest Friday Workout, which is always recommended reading.

A Bushel of Learning

I’ve written this on a train heading back to visit the Alderson family homestead. With me is a copy of “My Family and Other Animals”, which I picked up while traveling but was a childhood favourite. My folks wouldn’t mind being described as such, and certainly Gerald Durrell’s didn’t — in fact he laments in the foreword that he “made a grave mistake” by introducing them into the book early on, as they “proceeded to establish themselves and invite various friends to share the chapters”, which meant he had less pages “devoted exclusively to animals”.

It’s with something of that sentiment I’ll gloss over latest central bank developments in this edition, as our European Levfin Wrap already covers this admirably. Certainly the hawkish tone prompted credit spread widening this week, with the iTraxx Crossover index bleeding out around 21bps from its starting print of just inside 400bps. But signs on Friday of a slowdown in US jobs creation helped soothe concerns about the Fed resuming rate hikes from next week’s meeting.

Overall, credit spreads are starting to feel pretty range-bound, and Crossover ended today back in the middle of its recent corridor at 415bps.

iTraxx Crossover, via IHS Markit

What feels more important is how much this picture of regularity masks. It was a consistent theme of conversations this week — and admittedly I might be the common denominator in encouraging them — that dispersion plays are where the smart money is at.

As Jeff Boswell, head of alternative credit at Ninety One, pointed out, the overall index spread of the global high-yield market “masks significant diversity and a skew towards the expensive part of the index”. Through much of 2022, there was a notable lack of sector dispersion in global credit markets, with limited pricing differentiation between defensive and cyclical sectors.

“As expected, the market has snapped back since then, with a combination of a flight to quality and mass retreat from riskier segments sending dispersion soaring.”

He illustrated this with a chart relating to the ICE BAML Global High Yield Index.

source: Ninety-One

In conversation with Boswell about these findings, he explained the dynamics are fairly similar in the iTraxx Crossover index and CDX HY with higher dispersion (lower correlation) in both indices.

“Higher dispersion is that the index spread masks a sizeable part of the HY market that has become over extended/expensive from a valuation perspective,” he says. “This includes large parts of the BB rated universe. Instead of crowding into the ‘safe/quality’ part of HY, as an unconstrained investor we believe select parts of investment grade or even high quality CLOs / loans provide more compelling alternatives to higher quality parts of the HY market at the moment. In terms of time horizon it's worth noting that dispersion as described above tends to mean revert but can take some time so this is less of a short term trade for us.”

Overall the higher dispersion this year highlights that there are a number of opportunities for bottom up credit selection as there are both a sizeable number of outperformers and underperformers in the index. From a sector perspective, Ninety-One still finds decent relative value in financials.

The Speech for the Defence

As someone who has been fairly forthright in predicting the next recession, I have to doff a cap to Alberto Gallo, CIO at Andromeda Capital Management, for giving a compelling thesis for why this won’t happen — and nor will central banks pivot — in 2023. In a webinar this week he argued that demand remains the driver of sticky inflation in Europe rather than supply, and added that quantitative tightening is the ‘elephant in the room’ when it comes to this persistent dynamic.

via Andromeda / Bloomberg

“Interest rates in the short end are not doing enough,” he said. “Central bankers are only doing half of their job.”

Gallo believes questions around quantitative tightening will come back to bite some central banks just as they’re getting to target in short end rates. This, he added, will be a driver of potential fragilities in financial markets in the second half.

My attention immediately intensified hearing that Gallo sees parts of the market breaking if the long end of curves goes higher in the second half. It’s been my analysis from historic precedent that the normalisation of inverted US Treasury curves has usually been the surest signal for when a recession will actually start.

“Until the long end of interest rates goes higher, investors are not really encouraged to shift their preferences. You can raise the short end to 6%, 7%, 8%, but who really borrows in the short end? Unfortunately it’s small businesses and people that have more need for cash, that use credit cards and auto loans. But what really matters for long-term investors, for large companies, investment grade and high yield, and generally for 70% of the economy, is the medium and long-end part of the curve.”

In essence: with Treasuries where they are, the likes of Apple and MicroSoft can run a carry trade between the level they borrow at and the bonds in which they invest.

A Treasure of Spiders

Meanwhile, inverted yield curves widen inequality while doing little to reduce demand. 

via Andromeda

At around central banks’ target rate, balance sheet reduction will become a prominent theme in the second half, says Gallo. This will cause the tide of liquidity to turn with dis-inversion of the yield curve.

“If the 10-year Treasury goes above 4.5% or even above 4.25% a lot of market participants will be in pain. A lot of assets stuck in less liquid strategies — take, for instance, private debt, will need to reprice.”

Instructively, Andromeda’s strategic longs and shorts do not look to rely on a view of recession not happening. As such, some of their calls will have strong correspondence with those who do see recession as imminent. And they fit very well with a theme of broadening dispersion.

the Andromeda playbook

One house that does remain convinced that a recession is on the way in Q4 23 or Q1 24 is Deutsche Bank. This week the strategy team, led by Jim Reid, published a series of charts showing indicators of recession and its timing. One main finding is that investors cannot take confidence from today’s low unemployment numbers since these, at least in the US, have historically stayed flattish right until a recession starts. And then they leap up.

“The fact that unemployment is stable right now doesn’t mean that a recession isn’t going to happen. Indeed, if a recession does start within the next six months, current readings are perfectly in keeping with the historical pattern. Unemployment isn’t a leading indicator, so it’s not one where you get clues beforehand. You’d only expect to see it rise once the recession is actually underway.”

Deutsche also unpacks the seemingly contraindicative outperformance of equities, which have made strong gains in 2023 at an index level. Historically, in the two years preceding a recession, the S&P 500 index has done well on average until it's a year off. It has then tended to flatline before starting to fall 1-2 months away.

“If you just look at this year there is absolutely no signal from equities that a recession is coming,” says DB. But the strategists offer two caveats, one of which relates to the outsize influence a small number of companies have had on the index. 

“Firstly if we did get a recession by year-end its likely at this stage that the two-year lead-up to it would be the weakest equity performance in this post-WWII sample, so evidence of market concern in the lead-up as the rate environment completely changed. The second caveat is that the equal weight S&P 500 has been trading more sideways over the last year, and much more typical of what you would see if a recession was now six months out. So it depends on your view of whether those handful of mega-cap tech stocks can influence the macro outlook.”

An Entertainment with Animals

This resonates with what I wrote in my first ever Macro Prophet column, about how the true picture of financial markets is being distorted and disguised. 

Two months on, all is still not what it seems. At least these two are keeping it real.

Author’s photo: Ramses surprises MacDuff