12th August 2018

Fearing the spiral of contagion

iTraxx Main

68.0bp, +4.1bp

iTraxx X-Over

303.8bp, +11bp

🇩🇪 10 Yr Bund

0.32%, -6bp

iBoxx Corp IG

B+128bp, +2.4bp

iBoxx Corp HY

B+390bp, +7bp

🇺🇸 10 Yr US T-Bond

2.87%, -7bp

🇬🇧 FTSE 100 [wp_live_scraper id=”17″], [wp_live_scraper id=”18″] 🇩🇪 DAX [wp_live_scraper id=”19″], [wp_live_scraper id=”20″] 🇺🇸 S&P 500 [wp_live_scraper id=”21″], [wp_live_scraper id=”22″]

It’s Trump’s way, or the highway…

China, Iran, Turkey, Russia and the EU. Trump’s economic war has unleashed a spiral of contagion which is threatening to result in an uncontrollable drop in financial prices. Once an emerging market nation can’t roll over its obligations drawing (over) exposed Western financial institutions into the net, then we have the makings of a financial crisis – which could become systemic. We’ve been here before, famously with the Asian financial crisis as the likes of Indonesia, Thailand and Malaysia succumbed and the contagion quickly took in LatAm and other Asian countries.

Now, hot money and other flows are in retreat again as confidence is sapped in Turkey. And Turkey hasn’t helped itself, the Turkish President choosing to ignore the might of the financial markets in favour of divine intervention. Trump’s rather symbolic doubling of aluminium and steel tariffs along with a defiant rambling speech by Erdogan (lacking compromise or conciliation) saw to it that the currency was crushed – and the domestic banking sector will follow, very soon.

Right now, Turkey is a bigger problem for EM and the markets than Russia and Iran combined, while the ‘trade war’ the US is embarking on with China and the EU – for starters, has materially lowered the barrier for a global financial crisis.

Turkey is in it, and deep. It has a very high level of private sector debt and an economy with an over-reliance on (economically non-productive) construction. The country’s current account position resembles that of Thailand and Malaysia back in the mid to late 1990s – that is, extremely weak – and needing sharply higher rates (and investor confidence) immediately to attract dollars the country is so reliant on to fund the deficit. Failing to do so means that the banking sector is on the hook. It’s the perfect storm and the country is out on a limb. The markets are running scared. And rightly so.

The ammunition at the mercy of the central banks has diminished markedly in terms of how effective any easing might be should we threaten to slip into systemic crisis. On a worst-case basis, this time next month, the BoE could be cutting again (having just raised rates) while the ECB might be forced to reassess ending QE at the end of the year. We’d think that the US will do very little to change course on policy but might postpone future rate hikes.

The best case sees Turkey manage to quash the current decline with an aggressive policy response (unlikely, unfortunately) – as well as the release of the US pastor as a gesture of goodwill – and that there is some cooling in the Russia/US tensions which sees the ruble stabilise. The rest continues ‘as is’ with the US administration seemingly in no mood to pull back from getting on a more equal footing with its global trading partners. The markets could quickly stabilise then at current levels, helping us find a floor before we await the next move from an erratic and unpredictable US President.

We hope for the latter, but must be thinking about positioning for the former. No one is yielding any ground and the weapon of choice this millennium is economic and the US is the biggest gunslinger in town. There’s possibly no middle ground in which to muddle our way through. Just as well we’re in the summer months. Unfortunately, summer liquidity across all markets is always extremely poor and that means we have exaggerated moves on more limited trading volumes and flows. So some of the extreme moves can be put down to an extremely defensive Street support bid for anything. Either way, higher beta risk is off everyone’s menu.

Credit markets weakness follows equities

In credit, primary activity was largely confined to Volkswagen in sterling while its leasing subsidiary offered up a three-tranche euro-denominated deal. With markets in turmoil, we can discount any further opportunistic funding. Up until last Friday’s escalation in tensions, it looked like we might be in the midst of a summer flurry in deals, with enough sidelined cash looking to get invested even in these holiday weeks. No more.

In secondary, financials and higher beta risk were obviously seeing the worst of it. BBVA and Unicredit might be amongst the most exposed through their exposures to Garanti Bank and Yapi Kredi Bank respectively, but the ramifications will be felt through the entire banking sector (BNP also boasts a sizeable operation, for example).

The Markit iBoxx IG cash index closed 2.4bp wider at B+128bp, but the rally in the underlying pushed returns higher. Benchmark spreads are now 2.5bp wider this month and 31bp wider this year, but IG total returns are back in the black for the year to date, at +o.05%! The financial index widened by 3bp on Friday and the non-financials by around 2bp while the high beta CoCo index took an 18bp hit to B+520bp and is at the widest level since late July.

Into it all, the high yield market was also wider, the index left at B+390bp (+7bp) at the close. So, overall a harbinger of what we might expect if events spiral out of control which they easily can. Geopolitical stresses allied with that trade war amid a background of rising rates are a perfect recipe for flushing out the weakest links, but such is the incestuous nature of the financial system, we will soon realise that the Emperor also has no clothes.

Uh oh…

Just a couple of weeks ago, Treasury yields in the 10-year were looking to park up at 3.00% or more and Bund yields at 0.50%, but the flight-to-quality haven-trade has seen them in sharp retreat. Those yields are now at 2.87% (-7bp) and 0.32% (-6bp), respectively, while Gilts also caught a bid as UK banks will also be exposed (10-year yield lower at 1.24% (-6bp) although there might be signs that the 2nd quarter rise in GDP (to 0.4% from 0.2%) might be followed with a slow trajectory in Q3. The UK won’t be the slowest growing of the G7 for the first half, and will likely up there near the top although well behind the US!

Front-end yields are also edging lower with 2-year Bunds yielding -0.64% (-2bp) and the 5-year -0.30% (-3bp). European banks (especially German ones) are under some pressure and equities fell hard on the follow, with Friday’s session seeing declines of 2% in the DAX, for example.

The US markets closed 0.7% across the main equity indices. Turkey failing to come up with anything fresh which could calm the situation and return a semblance of order will likely result in continued defensiveness across the markets this week.

There isn’t too much elsewhere in terms of data to focus on as the earnings season draws to a close and macro data is light. There is though another round of Brexit talks.

We were due to publish on Wednesday, but events in Turkey necessitated a comment. Unless the outlook worsens materially, we will be back next Wednesday, 22 August.

Have a good day.

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Suki Mann

A 30+ year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on CreditMarketDaily.com.