Monday, December 14, 2015

This is not a replay of 2008

Markets are once again in a tizzy over junk bonds, mainly of the oil variety. The situation in the oil patch is pretty dicey, no doubt about it, but aside from that it's hard to find much genuine distress. Lots of panic selling in a few areas, but no systemic distress. From the looks of key indicators, this is not a replay of 2008.

The chart above shows investment grade credit spreads as measured by the Merrill Lynch Corporate Master Index, as of Dec. 11th. Spreads are somewhat elevated, to be sure, but they are not even close to the distressed conditions we saw in late 2008. They are about the same today as they were before and during the 2001 recession, which was the mildest on record.

High-yield credit spreads are significantly higher than investment grade spreads, but the difference between HY and IG spreads (shown in the second chart above) is still significantly shy of what we have seen during genuine periods of economic and financial distress.

Once we drill down to the energy sector of the HY market, however, we see the main source of today's market angst. The market value of HY energy bonds has dropped fully 30% from the highs of mid-2015, which was just before oil prices started to collapse. Crude oil futures are now down to $35 per barrel or so, which is a long way from the $110+ prices which prevailed during the first half of last year.

Here are some relevant statistics: Energy-related HY corporate bonds represent about 15% of the HY debt market, but the losses in this segment represent about half the losses of the entire HY market. That implies that losses on non-oil HY bonds are only about 6%.

The chart above shows the price of HYG, which is an ETF that targets the liquid bonds in the iBoxx HY Index. Note the massive increase in trade activity last week, when more than 54 million shares traded hands on Friday, as compared to 10 million or so daily during a normal week. This has all the earmarks of the panic selling described in a recent WJS article. Investors trying to escape the damage in the oil patch have triggered a wave of selling that has affected the entire HY sector.

But there's one thing missing from the "panic" story. Swap spreads, shown in the chart above, are not displaying any signs of distress, either here or in the Eurozone. Swap spreads are relatively low and stable, which means that liquidity conditions in the financial markets are normal. Large institutional investors can buy and sell risk easily, and in quantity, without having to pay high prices to do so. Swap spreads say that systemic risk is low, which is another way of saying that the distress in the HY market and in particular in the oil patch has not proved contagious to the larger economy. This is very different from the situation in 2008, when the distress in the housing and in particular the MBS market did prove contagious—and highly so.

Systemic risk also fails to appear in the prices of gold and 5-yr TIPS, as the chart above shows. The prices of both of these safe-haven assets have been on a declining trend for several years. If things were really falling apart, the two lines in this chart would be headed skywards. But they're not.

Collapsing oil prices have already resulted in a two-thirds decline in the number of active oil drilling rigs in the U.S., so we know that the current glut of oil supply is on its way to reversing, and in time oil prices will firm. Lots of money has been and will be lost in the oil patch, but even today the losses that have been registered in oil-related energy debt are quite small, on the order of $60-65 billion. That's a drop in the bucket of U.S. asset markets, and a very tiny fraction of the $80 trillion of net worth that resides in the U.S.

This is not a time to panic, it's a time to find value outside the oil patch. It's one more "wall of worry" that we're likely to leave behind.


Matthew Grech said...

I don't have the guts to buy oil here. But I would just point out that the ratio of an ounce of gold to a barrel of WTI was over 30 this morning (29.4 right now). That is, historically, extremely high.

Scott Grannis said...

Good point. That ratio has rarely been as high as it is today (32.7 currently).

Scott Grannis said...

The ratio I'm quoting is spot gold vs Arab Light.

Scott Grannis said...

One further observation: crude relative to gold looks very cheap, which implies that gold relative to crude is very expensive. I can see the ratio returning to more normal levels via rising crude prices and further declines in gold prices.

NormanB said...

The two year swap spread at these low levels is only the perception that the risk is low. It doesn't mean that the risk is actually low. In fact, such a low amount of perceived risk might in and of itself smack of complacency. When the two year gets high it is to late to get out.

Scott Grannis said...

The swap market is a very large and liquid market. Swap spreads are a proxy for the cost of doing transactions in the swap market: exchanging one form of risk (e.g., interest rate risk, forex risk, credit risk) for a riskless rate (e.g., Libor). When swap spreads are low, these transactions can be done very cheaply, and that in turn means that there is plenty of appetite in the market for accepting risk. This is all done in real time, and it is based on real transactions. It cannot be ignored or dismissed lightly.

steve said...

To your point re HY, I think they are a bargain now but am waiting for a sign of bottom. HY tends to trade based on PERCEPTION of strength in the economy which at least ostensibly is OK. but they're trading like we're recession bound-and maybe we are-but I doubt it. look for a strong return in HY sometime fairly soon. it should be pretty obvious.

Benjamin Cole said...

Nice post. And has everyone forgotten? Cheaper commodities are good!

BTW, I think recent developments in batteries and much higher MPG vehicles are some of the best news we have had in decades.

I suspect there is a ceiling now on oil prices, may be in the range of $90 - $100 barrel. Oil may spike through that level, but that will generate declining demand.

I think we have hit Peak Demand before we have hit Peak Oil.

Good news!

William said...

WSJ: Financial Obfuscation of the dot-com Era is Making a Comeback

"A financial obfuscation of the dot-com era is making a comeback: Hundreds of U.S. companies are trumpeting adjusted net income, adjusted sales and “adjusted Ebitda.”

These adjusted measures paint a rosier picture of corporate earnings. Without them, third-quarter earnings per share fell 13% for the biggest U.S. companies, according to Deutsche Bank research, instead of falling 0.1% with them.

About one in 10 major securities filings this year used the term adjusted Ebidta—or adjusted earnings before interest, taxes, depreciation and amortization—up from one in 40 a decade ago. About a quarter of earnings-related filings this year included figures that don’t comply with generally accepted accounting principles, or GAAP, as well as more standard measures, according to a Wall Street Journal analysis of 10-K, 10-Q and 8-K filings."

Scott Grannis said...

Re adjusted earnings. This is one reason why I think it is important to track corporate profits as calculated in the National Income and Product Accounts. Those profits are based on data supplied by corporations to the IRS. They can't be restated or twisted, and are very unlikely to overstate reality. That measure of profits continues to be very strong, both nominally and relative to GDP.

William said...

Scott, what is the year-over-year growth in NIPA profits through September 30, 2015?

Thank you.

smokeyd said...

One issue is also that the credit quality has migrated down since the GFC so a like for like comparison (rather than "all" grades) ie BB to BB show that margins are nowhere near GFC and are more like a 1998 type event said...

Thanks, Scott.

Just as I would have thought.

Clinton Condo said...

Hello Mr. Grannis. Thank you for the informative blog.

RE: National Income and Product Accounts "Corporate Profits".

Is there a way to know in precise detail which segments of an industry are included in the BEA categories? Example, corporate profits for "information". What are these "information" industries specifically?

It is difficult to research specific groups of companies given the broad categorization used by BEA.

Any help is greatly appreciated.
Happy New Year!