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Credit Tremors Summary

Core Content

This report analyzes the current state of corporate credit markets, focusing on the underlying causes of weakness and its implications for recession and systemic risk. It includes expert insights from Goldman Sachs (GS) and AllianceBernstein (AB) as well as academic perspectives from NYU Stern Professor Edward Altman. The report also examines key sectors—energy and European financials—as well as global economic trends and market fundamentals.

Main Viewpoints

1. Credit Market Weakness and Recession Fears

• Credit spreads have widened significantly, reflecting heightened fears of recession and systemic risk.
• However, the report suggests that the current credit market weakness is more related to liquidity issues and commodity price collapses than to a broader decline in risk appetite.
• The weak credit market is seen as a vulnerability to the economy, but not as a direct trigger for a recession.

2. Expert Perspectives

• Charlie Himmelberg (GS Credit Strategist):

  • The current credit spread levels are driven by commodity price collapses and liquidity issues, not necessarily by US economic growth.
  • He warns that the low liquidity in credit markets could amplify price declines in response to fundamental shocks.
  • Mutual fund redemptions and ETFs are seen as potential risks, but ETFs may help maintain market liquidity and price discovery in times of crisis.

• Ashish Shah (AB Credit CIO):

  • While he doesn't believe the US credit market will be the trigger for a crisis, he acknowledges the substantial risk of a global crisis due to weak growth and ongoing Fed tightening.
  • He is skeptical of the role of credit ETFs, arguing that passive investment in debt markets could harm portfolio credit quality.

• Edward Altman (NYU Stern Professor):

  • He expresses concern about the link between credit markets and economic growth, noting that a large bubble in corporate credit exists.
  • He warns that a US recession or a major downturn in China could trigger a credit crisis.
  • He believes that credit market weakness could lead to a recession, citing historical default rate trends before past US recessions.

Key Concerns

1. High-Yield Energy Sector

• The energy sector is currently experiencing distressed valuations, but the report suggests it is unlikely to generate credit losses or bank failures comparable to the subprime crisis.
• Jason Gilbert (GS Energy Credit Research) notes that while the sector is weak, there is not yet enough evidence to suggest a buying opportunity.
• The report highlights that energy companies are still optimistic about a rebound in oil prices, which would reduce the risk of default events.

2. European Financials

• European bank credit spreads have widened, raising concerns about systemic risk.
• However, Jernej Omahen and Nick Butler (GS Equity Research) argue that systemic risks are minimal.
• The report emphasizes that European financial institutions are not currently at risk of a collapse, despite the challenges in the sector.

Market Fundamentals and Technicals

1. US Market

• Fundamentals:
  • The US economy is not in recession, and corporate leverage has increased, but the low-rate environment has allowed companies to lock in lower interest rates.
  • High personal saving rates suggest potential for consumer spending growth.
• Technicals:
  • Liquidity has deteriorated significantly, leading to a challenge in managing single-name credit risk.
  • Credit ETFs are seen as a partial solution to liquidity issues, but they do not fix the underlying micro-level liquidity problem.

2. Euro Area (EA)

• The ECB is expected to increase asset purchases to €70bn and introduce a tiered-rate system.
• The report identifies three key downside risks to growth: global industrial slowdown, bank funding stresses, and political risks (e.g., refugee crisis, Brexit).
• Credit conditions have eased, but the risk of a systemic crisis remains low.

3. Japan

• The BOJ is expected to wait until the negative rate concerns subside before easing further.
• Core CPI has fallen to 0.0% in January due to slowing prices in food and durable goods.
• A drop in consumption has affected 4Q GDP growth.

4. Emerging Markets (EM)

• China's credit growth has surged due to demand for RMB borrowing to pay down USD debt, though trade and activity data remain weak.
• Mexico has implemented a coordinated fiscal and monetary policy response, which is seen as a positive differentiator in the EM space.

Credit Risk and Valuation

1. Credit Risk Premium (CRP)

• The current credit risk premium is higher than historical norms, even in a mild recession scenario.
• The CRP is calculated as the difference between current spreads and expected loss rates, and it remains attractive despite the current economic climate.

2. Default Rates

• The report forecasts a gradual increase in HY defaults in 2016, with a 12-month trailing default rate expected to rise to around 4.5%.
• IG default rates are also expected to rise, but remain below historical averages.
• Credit spreads are currently at their 84th percentile (HY) and 87th percentile (IG) over the past 30 years, indicating a high risk of recession, though not yet realized.

Investment Implications

• Credit markets are pricing in worse fundamentals than expected, suggesting that the current environment is not reflective of the actual economic conditions.
• Investors should be cautious about interpreting credit spreads as a direct signal of recession, as they are more influenced by technical factors like liquidity and ETF dynamics.
• The report emphasizes that while the market is weak, it is not necessarily heading toward a systemic crisis.
• ETFs and credit strategies are seen as tools that can help maintain liquidity and price discovery, though they are not a cure-all for the broader issues in the market.

Conclusion

The current credit market weakness is primarily driven by commodity price collapses, liquidity issues, and market technicals rather than a broad decline in risk appetite. While concerns about recession and systemic risk are present, the report suggests that the US credit market is unlikely to be the trigger for a global crisis. The energy and European financials sectors are key areas of focus, with the former being less likely to cause widespread credit losses than the subprime crisis and the latter showing minimal systemic risk. Credit investors should remain cautious but not overly alarmed, as the market is still pricing in a scenario that may not materialize.