It is the 19th of September 2019

"The Dreaded Phase 4": What Happens When Credit Spreads Finally Rise

With investors, traders, analysts and pundits focused on the chaos in the White House, and the daily barrage of escalating geopolitical and social news, whether terrorist attacks in Europe or clashes in inner America, the market is finally starting to notice as Friday's last hour sell-off demonstrated. And yet, according to one of the best minds on Wall Street today, Citi's Matt King, what traders should be far more concerned about, is not who is in the Oval Office or how bombastic the war of words between the US and North Korea may be on any given day, but rather what central banks are preparing to unleash in the coming months. To underscore this, two weeks ago, King made a stark warning when he summarized that we are now more reliant on central banks banks holding markets together than ever before:

"with asset prices displaying a high degree of correlation with central bank liquidity additions in recent years, that feedback loop makes the economy, upon which both corporate profitability and bank net interest margins depend, more reliant on central banks holding markets together than almost ever before. That delicate balance may well be sustained for the time being. But with central banks beginning to move, however gingerly, towards an exit, is it really worth chasing the last few bp of spread from here?"

One week later, he followed up with what was arguably his magnum opus on why the market is far too complacent about the threat to risk assets from the upcoming rounds of balance sheet normalization, summarized best in the following charts, showing the correlation between central bank asset purchases and the returns across global stock markets. The unspoken, if all too familiar, message was that riskier financial assets, such as credit and equities, have been artificially boosted by central bank actions, actions which are soon coming to an end whether voluntarily in the case of the Fed, or because the central bank is simply running out of eligible bonds to monetize, in the case of the ECB and BOJ.

In short, King is worried the global market is about to enter another tantrum.

Is he right?

To answer that question, another Citi strategist, Robert Buckland, admitting that "we are (always) worried", takes a look at where we currently stand in the business cycle as represented by Citi's Credit/Equity clock popularized also by Matt King in previous years.

For those unfamiliar, here is a summary of the various phases of the business cycle clock:

  • Phase 1: Debt Reduction – Buy Credit, Sell Equities

Our clock starts as the credit bear market ends. Spreads turn down as companies repair balance sheets, often through deeply discounted share issues. This dilution, along with continued pressure on profits, keeps equity prices falling. For the present cycle, this phase began in December 2008 and ended in March 2009. Global equities fell another 21% even as US spreads tightened.

  • Phase 2: Profits Grow Faster Than Debt – Buy Credit, Buy Equities

The equity bull market begins as economic indicators stabilise and profits recover. The credit bull market continues as improving cashflows strengthen company balance sheets. It’s all-round risk-on. This is usually the longest phase of the cycle. This began in March 2009, and according to most Wall Street analysts, is the phase we find ourselves in right now. Equity and credit investors both do well in this phase.

  • Phase 3: Debt Grows Faster Than Profits – Sell Credit, Buy Equities

This is when credit and equities decouple again. Spreads turn upwards as fixed income investors become increasingly worried about deteriorating balance sheets. But equity markets keep rallying as EPS rise. Share prices are also boosted by the effects of higher corporate leverage, often in the form of share buybacks or M&A. This is the time to favour equities over credit.

  • Phase 4: Recession – Sell Credit, Sell Equities

In this phase, equities recouple with credit in a classic bear market. It is associated with a global recession, collapsing EPS and worsening balance sheets. Insolvency fears plague the credit market, profit warnings plague the equity market. It’s all-round risk-off. Cash and government bonds are usually the best-performing asset classes.

* * *

The reason why Citi is concerned where exactly in the business cycle the US economy and capital markets are to be found at this very moment, is that as Goldman showed recently, corporate leverage has never been higher...

... and yet, corporate spreads remain at or near all time lows. Behind this paradox is - once again - the active intervention of central banks, and explicitly the ECB, which starting in March of 2016 announced its plans to start purchasing corporate bonds, sending corporate spreads to record lows, and in some cases, pushing junk bonds yields below matched US Treasurys.

Or, as Citi puts it, "Central banks hold back the clock"

Citi credit strategists suspect that this central bank intervention decoupled credit spreads from the underlying company balance sheets. As corporates lift leverage, we would normally expect the credit clock to enter Phase 3. Spreads should widen to reflect higher Net debt/EBITDA ratios. But that hasn’t happened in this cycle. In the last 18 months, corporate leverage has risen but credit spreads have fallen.

Buckland's summary is an echo of what we posted nearly a month ago in The ECB's Impact On The Bond Market In One Chart : "It seems that the corporate leverage clock has marched on to Phase 3, but the central banks have managed to hold the credit spread clock back in Phase 2."

Whatever the reason for the break in the business cycle, where we are currently located is critical as it could mean the difference between BTD across all assets, or, focusing on just a specific subset. In fact, it's all about credit spreads: as Citi explains, the credit market has turned up (spreads start falling) before the equity market early in the cycle and turned down before the equity market (spreads start rising) later in the cycle. This is also shown in the next two charts below which show the progression of high yield spreads and global equity markets across the 4 phases of the cycle:

Going back to the original trhust of the article, if indeed credit spreads are finally starting to rise due to excess leverage/central bank concerns, in other words if we are finally shifting from Phase 2 to Phase 3, what are the implications?

Key among them, is the as spreads rise, volatility follows, and market dips become bigger and more frequent, jeopardizing the profitability of the BTFD "strategy." Buckland explains:

If credit spreads do start to widen as central banks taper later this year, then we could finally move into Phase 3 of the credit/equity clock. What are the characteristics of this phase? And what are the investment implications for global equity investors?


Equities Up, But More Volatile


The credit/equity clock suggests that, despite widening spreads, equities can still generate decent returns in Phase 3. However, those returns are usually accompanied by higher volatility. This reflects the traditionally close relationship between credit spreads and volatility. As spreads rise, observed volatility (and the VIX) tend to follow (Figure 8). Investors should continue to buy the equity market dips, but these dips may get bigger and more frequent. While the headline equity market returns in Phase 3 are similar to Phase 2 (Figure 9), the risk-adjusted returns (Sharpe ratio) tend to be lower. The high return/low vol phase of the market cycle is over.

More importantly, this is the phase when bubbles emerge in full view, and in this case, the most obvious candidates for a bubble are global Growth stocks and US IT in particular.

It’s Bubble Time: Bubbles are common in these ageing equity bull markets. Indeed, all the great bubbles of the last 30 years have occurred in Phase 3 of the equity/credit clock (Figure 10). The late 1980s Phase 3 was dominated by Japanese equities, which rose to 44% of global market cap (now 8%). The late 1990s Phase 3 saw global Growth stock indices rising to unprecedented levels. The last cycle saw a sharp rerating of EM equities. All of these bubbles inflated even as credit spreads were rising. The bursting of these bubbles was a key driver of the subsequent bear markets.


Citi also issues a warning to value investors, whose "natural inclination to fight bubbles can get them into serious trouble at this point in the market cycle. The most obvious candidates for a bubble this time round are US Growth stocks and US IT in particular (Figure 10). We recently suggested that Growth stocks everywhere are looking expensive, but they are not yet in a bubble comparable to the late 1990s."

But the most critical aspect of timing Phase 3 is because the "dreaded" Phase 4 follows right after. Citi explains: "The strategies that work in Phase 3 get smashed in Phase 4. This is when a global recession pushes both equities and credit into a bear market. Bubbles collapse."

The problem with the advent of Phase 4, however, is that Phase 3 is inbetween, and even if the party is nearly over for corporate bonds (and spreads), it can continue for equities according to Buckland.

But how long does Phase 3 continue?

That's the question that everyone will soon be asking, and here is Citi's attempt at an answer:

Investing in Phase 3 is a dangerous game. Equity markets are moving into overshoot mode. This is nice while it lasts, but the dreaded Phase 4 may not be too far away. The late 1980s Phase 3 lasted 16 months. The late 1990s lasted 32 months. But in 2007 it only lasted 4 months.

Adding to the complexities of timing the transition from Phase 3 to Phase 4 is that - as observed twice already in this cycle - credit markets can give head fakes, especially if central banks step in to stop the sell-off. This is why when Buckland cross checks against the rest of Citi's Bear Market Checklist, he is comforted because even as "credit spreads are important factors in our checklist but they are not the only factors. The others help to reduce the head-fakes. For example, our bear market checklist helped us hold our nerve during the early 2016 sell-off even as credit spreads were signaling imminent doom."

Right now, only 2.5 factors out of 18 are worrying (Figure 14). If credit spreads widen significantly, we may turn them amber/red. But, everything else being equal, 4.5/18 red flags would still suggest that it is too early to call the move into Phase 4. However, we will continue to watch closely.

* * *

So as Citi refuses to sound an alarm, despite its increasingly more concerned research reports, and warnings about credit spreads, especially in the junk bond space, in theory, some of the biggest names in finance are quietly moving for the exits in practice, and as Bloomberg reported this week, "investors overseeing about $1.1 trillion have been cutting exposure to the world’s riskiest corporate debt as rates grind too low to compensate for potential risks."

These professional investors are worried for all the reasons voiced by Citi above: leverage is at record highs, yet even with the recent market turmoil stemming from North Korea and US political tensions, the Bloomberg Barclays index of junk bonds is yielding just above all time lows, or 5.3%, 100 bps below its 5 year average.

How much longer will it stay here, and how much longer will the market assume that we are still in Phase 2 instead of Phase 3? Some of the world's biggest money managers aren't waiting to find out, to wit:

JPMorgan Asset Management, AUM: $17 billion (for Absolute Return & Opportunistic Fixed-Income team)

  • In early July told Bloomberg they have cut holdings of junk debt to about 40 percent from more than half.
  • “We are more likely to decrease risk rather than increase risk due to valuations,” New York-based portfolio manager Daniel Goldberg said.

DoubleLine Capital LP, AUM: about $110 billion

  • Jeffrey Gundlach, co-founder and chief executive officer, said in an interview published Aug. 8 he’s reducing holdings in junk bonds and emerging-market debt and investing more in higher-quality credits with less sensitivity to rising interest rates.
  • European high-yield bonds have hit “wack-o season,” Gundlach said in a tweet last week.

Allianz Global Investors, AUM: $586 billion

  • David Newman, head of global high yield, said in an interview his fund has begun trimming its euro high-yield exposure because record valuations make the notes particularly vulnerable in a wider selloff.

Deutsche Asset Management, AUM: 100 billion euro ($117 billion) in multi-asset portfolios

  • Said earlier this month it has reduced holdings of European junk bonds.
    The funds are shifting focus to equities, where there is more potential upside and higher yields from dividends, according to Christian Hille, the Frankfurt-based global head of multi asset.

Guggenheim Partners, AUM: >$209 billion

  • Reduced allocation to high-yield corporate bonds across core and multi-credit strategies to the lowest level since its inception, according to a third-quarter outlook published on Thursday.
  • Junk bonds are “particularly at risk due to their relatively rich pricing,” portfolio managers including James Michal say in outlook report.

Brandywine Global Investment Management, AUM: $72 billion

  • Fund has cut euro junk-bond allocations to a seven-year low because of valuation concerns, Regina Borromeo, head of international high yield, said in an interview this month

* * *

Of course, the final complication, and what Citi did not mention, is that virtually all of the "safe" indicators in Citi's "recession/Phase 4 checklist" above are a function of funding pressures (or lack thereof) and thus, credit spreads. By the time there is a blow out in spreads - and yields - it will be too late to time the phase shift appropriately as the economy is likely already in a recession at that point. Which is why we find the Citi's spread guidance most useful:

What might tell us that the shift into Phase 4 is imminent? We find that US HY credit spreads (currently 400bp) of around 600bps are high enough to indicate an oncoming recession. The equivalent level for US IG spreads (currently 110bp) is around 175bp. Historically, equities have been able to handle spreads rising up to these levels, but anything higher gets dangerous.

Ultimately, the catalyst that finally sends the market (and economy) hurtling out of Phase 2 and Phase 3 and into the "Dreaded" Phase 4, will likely be the simplest, and oldest one in the book: more sellers than buyers... and as the list above shows, the sellers have arrived.

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