MatlinPatterson’s macro update for the first quarter ended March 31, 2015.
Investors attuned to asset prices are repeatedly taught that changes in price relationships foreshadow big changes in the prevailing market landscape. With that background, we have taken great interest in the recent divergence in U.S. credit and equity markets.
Over the past few weeks, we’ve been bombarded with a stream of headlines about new stock market highs — not only in the U.S., but across the globe. Even the Nikkei is at its post “lost decade” high. Conspicuously absent is a parallel highpoint in the credit markets, where spreads in the U.S. are actually wider since having bottomed (i.e. a peak in credit) in June of last year. This is particularly surprising given negative interest rates in Europe and the consequent planet-wide search for “yield at any price.”
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One often-cited reason for underperforming credit markets, especially in the U.S., is the exposure of the high yield market to the energy sector (about 17%). While true, there are a couple of caveats to consider. First, the credit lag is evident even in the high grade market where the concentration of energy is considerably lower (about 7%). Second, some high yield energy credits have actually outperformed their respective equities since the last time those equities were at this level. Furthermore, equity market volatility, another measure of risk premium, has also underperformed the broader equity market. This is true not only of the widely-cited but potentially flawed VIX index, but also of longer dated equity volatility measures.
Typically, the stock market and equity volatility move in lock step. Equity volatility, like credit spreads, bottomed in the summer of 2014, and has since rebounded to higher levels despite the rallying stock market. While a temporary dislocation between risk and risk-premium markets is not unusual, the recent persistence of this phenomenon is. Such an aberration last occurred in 2007 when credit spreads hit their tightest levels in February and subsequently widened despite a new equity market high in October of that year. A similar divergence occurred in 1998 when credit markets peaked (spreads hit their lowest levels) early that year while the equity market rallied for another two years before collapsing.
This credit-equity-volatility disconnect is typical late cycle behavior and suggests that “risk” markets are on shaky footing as the credit investor becomes less generous and more selective. The underpinnings of the equity market are then not as firm as they appear.
Just as the telecom sector was symptomatic of the excesses of the late 1990s, the energy sector today represents the most vulnerable corner of the credit markets. But are we then at the foothills of another credit cycle? Perhaps. But we’ve been jaded by the rapidity of the 2007 cycle when we went from peak to trough in about 18 months. The prior cycle, from early 1998 to mid-2002, took considerably longer. And if this is indeed the start of a similar phenomenon, then the underperformance of credit is likely to continue for a considerable period (pun intended) until the Fed takes the proverbial punch bowl away—something that may be delayed, but is no longer distant.
Indeed, the regulators have already begun the credit curtailment exercise, perhaps inadvertently. As a consequence of its Shared National Credit (SNC) review, the Fed is already “suggesting” that banks refrain from lending at more than 6x EBITDA. This overture isn’t official policy yet, and lies somewhere between suggestion and regulation. But given the current relationship between the banks and their overlords, the message needs no further encouragement. These marching orders are likely behind the considerable underperformance of the CCC sector since October of last year. The lower quality credit market is the most dependent on refinancing via the loan market, and these companies are the most exposed to credit headwinds in the immediate future.
MatlinPatterson: Greco-Lehman Wrestling
But what to make of the biggest credit problem of all: Greece? The recent Tsipras/Varoufakis antics are an unflinching reminder that credit is as much about a willingness to pay as the ability to pay, especially when one is torn between one’s creditors and one’s constituents. Regardless of how the Greek impasse resolves itself, the global financial markets’ ability to blissfully ignore Greece suggests that it expects one of two outcomes: (i) that a Greek default/exit is nowhere in the realm of possibility, or that (ii) even if Greece were to exit the Euro, the authorities have appropriately “foamed down the runway” to curtail any contagion and the world will emerge largely unscathed from Grexit.
While markets do indeed tend to be right more often than wrong, the recent tranquility seems to ignore the second-order effects of a Greek exit. If Greece were to exit, never mind the humanitarian tragedy the country would be forced to endure, the world would also immediately begin to question the sanctity of the European compact. What was once a bold political experiment will be reduced to a set of fixed exchange rates. Spreads on peripheral debt will start to widen as Euro membership turns into a marriage of convenience, and one that can be annulled without too much fuss. One is reminded of the days around the Lehman default when, in the first week, markets essentially ignored the Lehman filing (after plunging 500 points the Monday after Lehman filed, the Dow returned to almost unchanged levels by the end of the week). A few weeks later, money markets seized up, hedge funds found that their access to assets at Lehman were in doubt, and so began the Great Deleveraging.
The rest, as they say, is history.
But perhaps Mr. Tsipras’ recent “pivot” to Russia is a bold strategic move, and Mr. Putin will come to his aid, if only to irritate NATO. More importantly, while Greece may be the financial elephant in the room, the geopolitical one seems to be Russia. Never mind the Baltic incursions and the alleged Godfather-like treatment of political dissidents, overtly threatening the Danes with nuclear warheads aimed at Danish warships hearkens back to an era we’ve all long since forgotten, but it looks like we are all going to have to dust off our Cold War playbooks once again.
MatlinPatterson: And Now For Something Completely Different
After being the headline grabber until recent weeks, most global central banks have recently been relegated off the front pages. The bulk of central bank actions behind them, the markets are now in wait and see mode: The Fed has effectively told us that the threshold for tightening is higher and it is hell bent on not repeating its post-depression errors. The ECB, after much hand wringing, has finally given us a surprisingly robust QE. Now, the real wildcard is the People’s Bank of China (PBOC).
The slowdown in China is certainly not news, but the PBOC’s next response to the prevailing slowdown might just be. If the goal of the PBOC and its masters is indeed to rejigger the Chinese economy into a domestic, consumption focused one, then the recent slow and steady easing actions are justified, necessary, and possibly all we will see from that central bank. But they are now dealing with a currency that has strengthened considerably. The dollar-pegged RMB has risen alongside the greenback and the trade-weighted RMB is up almost 15% since last May—unusual for a central bank in “easing mode.”
Will the PBOC join the 2015 currency wars and devalue the Yuan? At first blush, that seems like the correct strategy. Faced with declining growth in general and slowing exports in particular, a weakening currency is one possible path back to prosperity. But that would have significant consequences for both China and the global economy. For one, Chinese corporations have built up significant amounts of foreign currency debt predicated on the stability of their currency and a large devaluation would cause considerable stress at home. Also, a large explicit devaluation would lead to further strengthening of the dollar, which will shade the Fed’s path. And finally, China has explicitly stated that it wants the Yuan to become the next reserve currency – a large one-off devaluation would undoubtedly undermine that effort.
MatlinPatterson: Of Babies and Bathwater
While the big macro markets continue to ricochet from one theme to the next, we think the recent volatility portends a strong environment for our core strategies. We have always maintained that a Fed-driven withdrawal of liquidity would allow us more opportunities as the “beta trade” ended. Interestingly, although the Fed (and ECB, BOJ, BOE, PBOC, Riskbank, RBI) are still some distance away from turning off the liquidity spigot, the credit markets have begun a liquidity curtailment exercise of their own with the beta trade almost working in reverse. The decline in the commodity complex, not just the energy sector, offers its own set of opportunities as unwieldy capital structures are hammered into shape by the market’s anvil. Value can be found in the lower quality credit markets – both in corporate and structured credit – and if the credit markets have indeed begun their long march downwards, we are excited about the opportunities the culmination of that journey will present.
Chief Risk Officer
See full letter below.