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Natural Normalization

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Apr 122011

Equity and Vol markets are starting to normalize relative to credit - we think more systemically as liquidity expectations are removed.

Spreads widened the most close-to-close since 3/25 with HY notably underperforming IG today as stocks continued the streak of eight of the last nine days relative underperformance to credit spreads. The euphoric dollar-weakness-driven rise in all things USD-denominated of the last week or two (not to say the last few months) that we noted had dragged many relationships from any empirical standards is starting to normalize with equity, credit, and vol all shaping up in the last two days and commodities and metals pulling back a little more to ‘recent’ trends relative to the dollar.

Very little movement in the major Dollar indices but Gold has normalized notably leaving Silver due for more correction we suspect

Notably the shifts in the risk asset markets today was hardly evident at all in the dollar (whether ADXY, DXY, or TWI) and in fact there was modest losses in TWI and DXY today while ADXY managed to hang in there. Gold pulled back and normalized (there’s that word again) with the recent dollar weakness as Silver (its higher beta brother) pulled back more but remains notably outperforming of its faux-currency brethren. The lack of excitement in the USD was however the exception among FX.

We think the G-7 power of intervention has faded now and point to the rising dispersion among JPY crosses as an indicator of this as it strengthens once again.

The dispersion that is evident in the JPY-crosses (carry pairs) is very notable in the context of last week’s moves where we saw an extreme lack of dispersion driven by JPY flow alone. It seems the huge rise in dispersion between several of the pairs fits with the thesis we have been discussing since late last week that this is all an exaggerated momentum rip on the back of the JPY intervention and its pump.

The Citi Economic Surprise Index is sending very different signals than the market is perceiving.

The ugly Trade Deficit numbers today and ongoing downgrades to Q1 GDP suggest trouble is ahead and we glimpse at one of the more useful indices around – The Citi Economic Surprise Index – for some insights that may quench the earnigs-hungry appetites of the bulls (remember our comments from yesterday on EPS vs FCF and its disconnection at peak margin and inflationary periods). As is clear the last month or two have seen a gradual shift lower in the surprise index (i.e. less positive surprises and more negative surprises) for the G-10 in general (charted here).
The picture is worse for the US specifically but don’t let that eat away at the backward-looking earnings data we will be presented with in the next few weeks and the forward-looking rosy pictures that will be painted that every company in the world is now a price-maker and not a price-taker (see Fastenal’s comments today) and margins can remain peak forever.
The main takeaway for us is that the last few times we have seen a significant slide in the macro prints, government intervention (QE1, QE Lite, QE2) has managed to kickstart us again – the clear fear is that we never really got the old-girl off the ground this time and the double-whammy of China tightening and Japan’s catastrophe is perhaps too big to handle this time (especially given the current bias away from fiscal stimulus).
Credit markets showed some volatility today, more so than we have seen in recent weeks, as dispersion rose among and across sector and quality cohorts. We have been clear that the decompression in spreads for the last few weeks (in the face of rising/flat equity markets) was worrisome (indicative of a turn in the credit-equity cycle as relevering is perhaps priced in) but it was in the context of the skew and term structure of vol that we saw more concern that equities (with their USD-numeraire) were perhaps more liquidity-driven in recent weeks than the more numeraire-free credit spread market (of course bonds trade in USD but their spreads do not).

Our SPY-IEF-LQD-based ETF Arb has been successful so far as equity has under performed credit.

The fact that credit decompressed pretty good today, and indices and intrinsics did not diverge, and yet still equities underperformed (beta-adjusted) tells us something about the normalization that is under way. Our ETF-based index arb continues to perform admirably after entering short at $17.4, the triangular arb is now trading under $15 and the z-score offers plenty more room for this to move. At the CDS level (based on our credit-vol/skew-equity framework), it is clear that credit is still sticking with its message of weakness but credit and vol are coming back its way. While it seems almost heretical to say it, credit is indicating a fair value more like 1150 for the S&P currently and this view is additionally confirmed by the upside-downside skew in vol-land.
We had discussed 3s5s flattening in HY early last week as a potential signal of concern (remember this is one of our low cost long vol ideas as a key macro hedge). The last week or so has seen the steepening resume but this time on a decompression in spreads – we believe this is more technically driven by macr overlays being place in the most liquid 5Y. At today’s 3s5s steepness in intrinsics for HY16 of 140-141bps, we are near recent steeps and would suggest a useful time to add to our flatttener. This 140-145bps range has been a short-term cyclical peak in the curve for the last five months or so and remains a canary we like to keep an eye on (and we do note that 3s/5s ratio has dropped now for three weeks). At the index level we saw modest 3s5s flattening today (as opposed to intrinsics) also as 3Y pops back above 300bps again much more in line with intrinsics.
All-in-all credit saw derisking in most credits as we had one of the most negative breadth days we have had in a while (about 6 wideners to every tightener). High beta names actually outperformed lower beta names which has the smell of a blanket derisking to it (which will lead to a more idiosyncratic unwind) but we do note that the wider spread names did underperform on the day also.
Media, Capital Goods and Leisure were the hardest hit credit sectors (even risk-adjusted) while Healthcare and Consumer-Noncyclicals were the best performers – though all sectors were wider in aggregate on the day. Across the broad universe of credit, Aramark, Ford Motor Credit, Universal Heath Services, Supervalu, and Dean Foods performed the best on a DV01-adjusted basis while wide trading names such as YRC Worldwide, Radian, Boyd Gaming, AMR, and Clear Channel all lost considerable ground. Interestingly highly referenced CDO-names underperformed the broad market while LBO-prone names outperformed suggesting a rotation to idiosyncratic risk control from systemic relevering expectations.

All sectors saw credit widening on the day but divergence is evident in several 'safe' and headline groups

Contextually, today was interesting bottom-up with only 53% of names agreeing in terms of direction for credit and equity risk (dominated by 50% agreement that conditions deteriorated). 27% saw credit widen as equity rallied while 20% saw credit compress as equities sold off but at the sector level the picture was much more stable with most agreeing systemically worse today. Leisure, healthcare, and Consumer Cyclicals were the only divergent sectors with credit underperformance as equity managed gains (only just in the latter we note).
While we saw a clear up-in-quality shift in single-name credit today ( a theme we have been suggesting recently), that was not the story in equities where higher quality names (BBB and above) actually underperformed on average those in the spec grade cohorts. Vol movements were in line with CDS once again with vol rising less for the better quality names and rising dramatically more for the lower quality names (with a particluar emphasis on the crossover names in fact).
Treasuries did not get any help from a POMO today (which we note the Fed annoucned late that the size opf firthcoming POMO auctions were lower than many expected) but didnt need it as we saw the equity weakness and slight dollar movement as a positive (especially in the belly around 5Y). Duration-adjusted the long-end was the best performer but the curve definitely had the butterfly feel to it that we discussed yesterdsy and we watch 2s10s30s start to track equity risk tick-for-tick again – remember last year when it took over as a carry trade.
Given the proximity of OPEX, VIX is tough to take much from but we note it rose modestly today but compressed from early in the day highs. The Skew similarly dropped very modestly but is impacted by the week. Implied correlation went perfectly sideways today after an initial apsike and drift back to normalcy but we do note that while index vols leaked slightly lower, only 12% of our universe showed single-name vols dropping (perhaps the early driver of implied correlation’s shenanigans).
The Bottom Line remains the same for us with a number of market and macro indicators flashing orangey/red and holding there. We suggest remaining fully hedged on ‘The A-List’, maintain the ETF Arb, and look to outperform idiosyncratically. An expectation of rising rates post QE2 (which we do disagree with as per above) has been posited as support for short-term spread compression in bonds but we note that it is the velocity of the moves that is critical and we suspect any move will be more violent than a hedging program’s outperformance in HY/IG could keep pace with.
Europe
Last night’s macro data was of no help and we saw general derisking in sovereigns as the snap tighter we saw last week is quickly scratched. It is increasingly clear that there is no solution other than real haircuts and a reset button and Greece (which bucked the compression trend last week) is leading us again the other way having broken back above 1000bps yesterday. Ireland and Portugal were worse performers today though but Spain came back in full focus as the IMF commented that while progress is being made they are not out of the woods (see yesterday’s note for our thoughts) and it rose to one week wides (above 200bps).
SovX was over 6bps wider on the day and whatever technical was keeping it rich has lifted as it pulled notably tighter to intrinsics on the day. GDP-weighted SovX widened 3.5bps to one week wides. Of course the weakness in sovereigns leaked into financials which saw considerable senior-sub decompression and seniors underperformed Main. The FINLs to Main spread differential, at 29.8bps, remains 14.8bps below where empirical expectations would see it given the SovX level of 165.9bps. The ‘cleaner’ FINLs to ExFINLs spread differential, at 37.2bps,is 26.3bps below relative to the SovX level of 165.9bps.
We also note that low beta credits are underperforming high beta credits in Main (similarly to the US) with the low beta (DV01-weighted) index at around 94.8bps, and the high-beta index around 101.5bps, compared to Main (intrinsics) at 97.5bps. Breadth was notably weaker in Europe than in the US today with very few names tighter on the day (Cable & Wireless and Smurfit Kappa were the sole XOver names that eked out tightening on the day).
Oil gave up more ground (WTI, Brent, and Brent in EUR) thank again to Goldman’s call and we note the implciiott underperformance of CEEMEA on the day though it remains 20bps wide of SovX. Lithuania and Latvia managed to outperform as Poland (debt deal) and Russia (oil?) underperformed.
Asia
The Fukushima plant remains front and center and while Kan and his colleagues put on a brave face, the ongoing and large aftershocks are not helping any recovery plans. We suspect the more aftershocks and the more Fukujima concerns rise the more likely we will see the JPY sttrength/repatriation trade actually take hold (and we suspect that is some of what happened today). We discussed at length our views on the USD as the new funding currency yesterday and the lack of any real move in USD today when JPY was shifting was perhaps a signal. Japan, Korea, and Malaysia were among the worst performing sovereigns on the day.
In line with this, Japanese corporate spreads jumped the most in almost three weeks but remain well below recent peak levels as financials lagged on the day. Asia ex-Japan decompressed in sympathy. Among our Asian credits rose 1.14bps (or 1.08%) to 106.52bps. Promise Co Ltd (6.65bps) is the worst (absolute) performer, whilst East Japan Railway Company (6.33%) is the worst (relative) performer. Toyota Motor Corporation (-2.08bps) is the best (absolute) performer, and also the best (relative) performer.
Index/Intrinsics Changes
CDX16 IG +1.25bps to 95 ($-0.04 to $100.19) (FV +0.89bps to 92.98) (84 wider – 20 tighter <> 51 steeper – 65 flatter) – No Trend.
CDX16 HVOL +2bps to 154 (FV +2.46bps to 152.11) (27 wider – 3 tighter <> 9 steeper – 21 flatter) – No Trend.
CDX16 ExHVOL +1.01bps to 76.37 (FV +0.41bps to 74.98) (58 wider – 38 tighter <> 53 steeper – 43 flatter).
CDX16 HY (30% recovery) Px $-0.31 to $102.38 / +7.5bps to 441.2 (FV +9.16bps to 429.18) (89 wider – 10 tighter <> 39 steeper – 58 flatter) – Trend Wider.
LCDX15 (70% recovery) Px $-0.08 to $101.375 / +2bps to 228.07 – No Trend.
MCDX15 +1.25bps to 150.25bps. – Trend Tighter.
ITRX15 Main +1.75bps to 97bps (FV+2.56bps to 97.45bps).
ITRX15 HiVol +2bps to 135.5bps (FV+3.59bps to 130.62bps).
ITRX15 Xover +9bps to 369bps (FV+8.02bps to 358.87bps).
ITRX15 FINLs +4.5bps to 126.75bps (FV+3.8bps to 126.19bps).
DXY weakened 0.22% to 74.89.
Oil fell $4.07 to $105.85.
Gold fell $10.68 to $1452.47.
VIX increased 0.5pts to 17.23%.
10Y US Treasury yields fell 9bps to 3.49%.
S&P500 Futures lost 0.79% to 1309.2.
Spreads were broadly wider in the US as all the major indices deteriorated. IG trades 4.1bps wide (cheap) to its 50d moving average, which is a Z-Score of 1.4s.d.. At 95bps, IG has closed tighter on 142 days in the last 587 trading days (JAN09). The last five days have seen IG flat to its 50d moving average. HY trades 17.1bps wide (cheap) to its 50d moving average, which is a Z-Score of 1.1s.d. and at 441.22bps, HY has closed tighter on only 57 days in the last 587 trading days (JAN09). Indices typically underperformed single-names with skews widening in general.
Comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY underperformed by around 0.7bps (or 10%). Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks underperformed HY by an equivalent 6.3bps (~ 84%), and stocks underperformed IG by an equivalent 1.7bps (~ 134%) – (implying IG outperformed HY (on an equity-adjusted basis)).
Among the IG names in the US, the worst performing names (on a DV01-adjusted basis) were Alcoa Inc. (+7.5bps) [+0.06bps], Expedia, Inc. (+6bps) [+0.05bps], and RR Donnelley & Sons Company (+5.5bps) [+0.04bps], and the best performing names were Loews Corporation (-4.5bps) [-0.04bps], Southwest Airlines Co. (-3.58bps) [-0.03bps], and DirecTV Holdings LLC (-3.5bps) [-0.03bps] // (absolute spread chg) [HY index impact].
Among the HY names in the US, the worst performing names (on a DV01-adjusted basis) were PMI Group Inc/The (+54.84bps) [+0.46bps], Radian Group Inc (+42.72bps) [+0.39bps], and McClatchy Co./The (+39.96bps) [+0.35bps], and the best performing names were Aramark Corporation (-25bps) [-0.25bps], Liz Claiborne Inc. (-10.76bps) [-0.1bps], and Universal Health Services Inc (-7bps) [-0.08bps] // (absolute spread chg) [HY index impact].