Snapshots is digesting the barrage of scandals, fast moving geopolitics, policy changes and market price action over the past two weeks. After a period of low volatility, the market seems to be waiting for some action before the year is up.

Confirmation Bias

We are reading Michael Lewis’s latest book the “The Undoing Project” which is about the Nobel Prize winning behavioural economists Tversky and Kahneman.  The book has made us question if a degree of confirmation bias is setting into this market.  It has continued to rally with very low volatility despite increasing warnings of expensive valuations and rising idiosyncratic risks.  Is there now a tendency to ignore new information and revert to the trend?  We have noted a pick-up in confident “absolute statements” from market participants.

Regime Changes

The reason we worry about confirmation bias is that there are a number of structural changes currently occurring in the market.  Some of these are:

-Diverging central bank balance sheets (most notably with the Fed shrinking and hiking, while the ECB is growing and on hold)

-Reduced economic spare capacity and employment slack;

-US tax reforms and cost of capital implications for highly leveraged companies from interest rate deduction changes; and

-China’s 19th Party Congress and the move to a market-based (rather than state-based) economy with explicit references to stamp out “systemic financial risks”.

Mongolian Deities

Another reason we worry is that valuations are expensive and terms are very loose in parts of the credit market.  CCC rated Mongolia issued just shy of $1bn at 5.625%.  According to Moody’s, CCC rated sovereign borrowers have a 6 year cumulative default probability of 42% and average recoveries are 30c.   The Bank of America Merrill Lynch Euro High Yield Index is trading at a YTW of 2.08%.  BB- default rates are marginally better and corporate recoveries higher, but again you have to skate very fast on thin ice!

To illustrate how loose terms are, UK retailer New Look reported a disastrous set of results with net leverage shooting over 12 times and it still didn’t trip a covenant.

Waterloo Blues

However, it is not all bad news.  We note that the recent European CLO conference took place in gloomy Waterloo and not Monaco or Barcelona.  It was well attended, the tone was subdued and investors felt underinvested.

Asif Godall
Co-Chief Investment Officer