Tue, 7 DEC 2021
If you want to know where the greatest downside risk exists; follow the leverage. Moreover, there is an intimate link between liquidity, leverage and volatility. As my astute Italian friend emphasized today, liquidity tends to be easier to attain when buying assets, but can evaporate during a downside correction in risk. Hence the observation that; you buy what you want, but sell what you can. That is especially true in the options and over the counter markets.
The other key line of defence is the risk compensation or premium an investor receives on an asset. Over an intermediate or long time frame it generally pays to buy an asset cheap. Put another way, buying an overvalued asset with narrow risk compensation, increases the odds of drawdown or loss. In contrast, a greater fool (or momentum) strategy is to buy something on the hope that one can sell it at a higher price to someone else in the future. That type of strategy also tends to be coincident with phases of rising and super-abundant liquidity. To be fair, that has been a profitable strategy through this cycle.
Another important lesson from the last two decades or more is that the credit market tends to lead on average at key cyclical turning points (by 6 months from bear to bull and 3 months bull to bear). In the current market cycle credit spreads have remained compressed even through the phase of equity volatility during the northern hemisphere summer. Indeed, you need to squint hard at the US high yield spread to see the ~50 basis point widening from the trough (chart 1).
By contrast, US equity volatility has remained above pre-pandemic levels and higher than would typically be implied by the credit markets. From our perch, US and developed market credit offers limited compensation or risk/reward compared to equities (spreads are low, interest rate duration is high and macro corporate leverage is elevated). On the positive side, elevated corporate leverage is not universal, with the mega-cap companies in a strong cash flow and balance sheet position.
In Asia, there has clearly been a non-trivial increase in the credit risk premium this year tied to the episode in Chinese real estate. While spreads are already trading at distressed levels well over 2000 basis points and comparable to post-Lehman levels in the United States, the widening has been warranted by the genuine balance sheet distress in the property developers. As we noted a few weeks ago, Beijing faces a prisoners dilemma. Ease credit now and support another expansion and recovery. Alternatively, start the transition to a new growth model, however painful that might be.
Tactically, it appears as though the authorities have capitulated and chosen to support growth similar to other mini cycles over the past decade (there was another RRR cut by the PBOC overnight). But a cyclical recovery will not mean that the old growth model is sustainable. Moreover, some Chinese property developers have already passed the point of no return. That is, new liquidity cannot overcome a legitimate solvency problem. Nonetheless, a re-acceleration in China’s credit impulse will likely support a mini cycle recovery in related assets. In a strategic sense we prefer exposure to companies levered to the new growth model. Specifically, the large internet platform companies which we added to last week.
Looking forward, credit spreads in the United States and developed markets are something to monitor with regard to the broader level of global risk appetite. The good news is that spread widening has been modest so far. However, that also means that developed market credit offers an attractive “hedge” (volatility premium/payoff) against a broader episode in risk.