The credit bull mar­ket’s sec­ond wind

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Ecuador de­faulted on its sov­er­eign debt in 1826, then again in 1868, 1894, 1906, 1909, 1914, 1929, 1982, 1984, 2000 and 2008. In prac­ti­cal terms, the coun­try has de­faulted on ev­ery debt in­stru­ment it has ever is­sued. But hope springs eter­nal, and surely this time will be dif­fer­ent? Last week, Ecuador tapped the mar­ket for US$2 bln at 7.95%. If noth­ing else, this un­der­lines how the hunt for yield among in­vestors re­mains in full force.

And why not? The US Supreme Court has just sided with in­vestors to ban­ish Ar­gentina to the equiv­a­lent of debtors’ prison, thereby en­sur­ing that coun­tries will be more re­luc­tant to de­fault in fu­ture—or, at very least, that the next coun­try to de­fault will not be as ad­ver­sar­ial as Ar­gentina and will set­tle more quickly. More­over, the world’s ma­jor cen­tral bankers have promised ei­ther to keep the print­ing presses hum­ming through the night (the Euro­pean Cen­tral Bank and the Bank of Ja­pan), or to keep in­ter­est rates at their floor for the fore­see­able fu­ture (the US Federal Re­serve). As a re­sult, credit in­vestors can be con­fi­dent they have both cen­tral banks and the courts in their cor­ner. So why not reach out for that ex­tra bit of yield? A sen­ti­ment which should en­cour­age the fol­low­ing:

1) The re­cent re­bound in emerg­ing mar­kets to con­tinue. Af­ter all, fur­ther falls in bond yields across the emerg­ing mar­kets will en­cour­age an ex­pan­sion in do­mes­tic bank­ing mul­ti­pli­ers and in­creases in in­fra­struc­ture spend­ing, trig­ger­ing pos­si­ble pro­duc­tiv­ity gains.

2) A con­tin­ued rise in merg­ers and ac­qui­si­tions and lever­aged buy­outs in de­vel­oped economies. In­deed, with the dif­fer­ence be­tween cor­po­rate bond yields and eq­uity earn­ings yields reach­ing ex­tremes in most mar­kets, the in­cen­tive to em­brace ‘fi­nan­cial en­gi­neer­ing’ (i.e. is­su­ing debt to buy back eq­uity) is at an all time high. And that’s be­fore go­ing into the change of fee struc­ture at most pri­vate eq­uity funds-which now charge man­age­ment fees only on cap­i­tal used, rather than on cap­i­tal com­mit­ted-which will only en­cour­age pri­vate eq­uity man­agers to be even more ag­gres­sive in this cy­cle than in the pre-cri­sis 2005-2008 cy­cle.

Of course, as stu­dents of fi­nan­cial his­tory know, reach­ing too ea­gerly for yield is a recipe for dis­as­ter, if only be­cause bond in­vestors, un­like eq­uity in­vestors, are not will­ing to ride losses through the cy­cle. So the cur­rent hunt for yield across all cat­e­gories of the fixed in­come uni­verse might look wor­ry­ing.

But in a world of zero in­ter­est rates, in­vestors seem happy to brush their con­cerns aside. That leaves two pos­si­ble near term risks to the cur­rent be­nign en­vi­ron­ment.

The first risk would be a change in pol­icy by the world’s ma­jor cen­tral banks. The most likely trig­ger would be a re­bound in in­fla­tion, per­haps driven by higher oil prices as the Mid­dle East­ern con­flict dis­rupts sup­plies.

Clearly it looks as if Janet Yellen’s Fed will be con­tent to stay be­hind the curve, but that does not mean a rise in in­fla­tion would not im­pact mar­kets. Higher prices would hurt ei­ther US dis­pos­able in­comes (es­pe­cially if the rise comes through prices for food, en­ergy or hous­ing), squeeze US cor­po­rate mar­gins (if the rise is wages), or in­crease the vo­latil­ity of the eco­nomic cy­cle (if the rise pushes com­pa­nies to stock­pile goods). As a re­sult, we would not be sur­prised to see ‘the pick-up in US in­fla­tion’ be­come the mar­ket’s main source of con­cern over the com­ing months.

The sec­ond risk would be an in­crease in de­faults. Granted, with in­ter­est rates at such low lev­els and eco­nomic ac­tiv­ity still ex­pand­ing, it is hard to see what the cat­a­lyst for a rash of de­faults might be. Per­haps a spike in en­ergy prices might lead to a de­te­ri­o­ra­tion in the cur­rent ac­count bal­ances of weaker is­suers like Greece, Spain or In­dia.

But apart from a rise in US in­fla­tion, or a po­ten­tial spike in oil prices, it is dif­fi­cult at this stage to see what could shake the com­pla­cency of all those in­vestors reach­ing out so ea­gerly for yield. In­stead, it seems far more likely that the low cost of fund­ing com­bined with the sta­ble macro en­vi­ron­ment will trig­ger the next wave of M&A and LBO ac­tiv­ity. If you thought Ecuador’s abil­ity to is­sue 10-year debt at 7.95% was a late cy­cle in­di­ca­tor, wait and see the rates at which in­vestors will lend money to Ukraine, Iraq, or Afghanistan in a few months’ time!

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