3rd October 2016

Thinking the unthinkable

MARKET CLOSE:
FTSE 100
6,899, -20
DAX
10,511, +105
S&P 500
2,168, +17
iTraxx Main
72.5bp, -0.5bp
iTraxx X-Over Index
330bp, -2bp
10 Yr Bund
-0.12%, unchanged
iBoxx Corp IG
B+127.5bp, +1bp 
iBoxx Corp HY Index
B+446.8bp, +1.5bp
10 Yr US T-Bond
1.59%, +3.5bp

It’s in the back of our minds, only…

deutsche-bank

Fall from grace: The once mighty Deutsche Bank

That was a difficult end to the quarter, if ever there was one. The stench of a potential global systemic financial mishap of almighty proportions is in the air. We don’t believe in the worst case scenario, but the drama could yet unfold into a crisis.

That drama is around Germany’s once finest institution – Deutsche Bank, where the potential for its demise is the hedge funds/fast players’ dream. They’re gunning for the bank, its CDS at over 250bp (5-year), its 6% CoCo at around all-time lows of 69c (at one stage on Friday), and its share price battered all combining to leave the institution battered and limping badly. €250bn of balance sheet liquidity won’t cut it.

The politicians have dug themselves a hole in how they might potentially bail-out the bank – if needed – given the massive regulation put in place post-2008. But, they’ll do it. If push comes to shove, they will have to, because they have no choice. We don’t profess any insight as to how the Deutsche Bank story will end, but we will be very surprised if it unravels uncontrollably into a systemic financial crisis.

If that worst-case happens, the bid for safe haven government bonds will rocket and yields plummet. Equities will collapse – everywhere. Corporate bonds will feel the pain too – but we don’t think necessarily as bad as they might have done had it been the 2008/9 era (that’s no consolation, admittedly). The CDO/Lehman systemic crash might pale into insignificance compared to a structurally more systemically important and significant an institution as Deutsche Bank going down. The euro currency’s viability will come under intense scrutiny – as will that of the Eurozone per se. And emerging markets will topple (debt, equity, other asset prices).

Worse, we would think that the policy response will not be as effective in containing any fallout as it was when the Lehman crisis flared up. We already have QE, we already have cut rates to the bone – well, we’re exposing the marrow – and governments are already very highly indebted. We can’t really add much more to that! Yes, you get the picture: Deutsche Bank is too big to fail.

Starting Q4 with a clean slate

Performance-wise, we start with a clean slate, although the aforementioned issues linger. Nevertheless, there was hope on Friday – as well as in reports over the weekend – that the Department of Justice fine for Deutsche would be reduced to under $6bn from $14bn which gave rise to a better close for risk assets. A fine is a fine, is a fine… but the structural issues remain and others will be dragged into it all in due course. Still, we reset the ticker and see how we will fare this quarter.

As for the rest, we can be warmed in how markets have recovered after a difficult start to the year and held on to gains, especially corporate credit in sterling will have left investors fairly comfortable with their subsequent gains. That is, Euro-IG credit has returned 6% this year (Markit iBoxx index) and the HY market 6.6% – but both have been trounced by the longer-duration sterling corporate bond market which has delivered gains, on a total return basis of almost 15%.

Financials have returned 4.2% in Euro-IG while non financials, as expected, have returned the bulk of the upside, returning 7%. All that after we closed out the month slightly on the back foot though, with spreads all weaker in September (by 7.5bp in IG, 31bp in HY but just 3bp in sterling corporate index). The rally in government bonds has kept corporate bond returns propped up, while the ECB and BoE’s QE has kept spreads from widening more.

Sterling corporates top returns YTD

Primary markets: fits and starts

The primary market saw a decent September for HY (over €12bn) while the sterling market for both IG and HY both surprised to the upside. As for IG Euro non-financials, almost €30bn was issued but just €10bn of that came in the second half of the month admittedly into some fairly volatile market conditions.

The FOMC was to blame although last week, the concerns around Deutsche Bank didn’t seem to put borrowers off. At one stage, it looked as of we would get a €40bn+ month for only the third for this year. So we fell short. The total year-to-date in this category now comes up at €215bn and we are looking in the context of around €270bn getting done by the time 2016 draws to a close. The record (over €290bn in 2009, Dealogic data) is likely intact for another year.

The demand for new issues is firmly intact if only measured by the ability of syndicate desks to almost consistently tighten initial guidance by 10-15bp. We all know their game, expect it and accept it. It’s not even about clever marketing which is sucking investors in. It’s just about fear (about not getting in on a winning deal) and greed (about not getting in on a winning deal)!

Secondary seems to be dominated by the ECB but the level of interest (currently running at €2.5bn a week) isn’t – strangely – helping spreads tighten, although it could be that we would be much wider on the back of macro volatility had the ECB not been around doing its QE operations. Our target of B+100bp for the Markit iBoxx IG index by year-end, from B+127bp currently is therefore looking a very tough ask.

Macro focused on Tories and payrolls

This week has focus on the UK Conservative Party conference and September’s non-farm payrolls which are due on Friday. We closed last week with Bund yields in 10-year maturities at -0.12% having seen -0.16% and where the direction is more dependent, at the moment, on event risk (around Deutsche/Commerzbank and perhaps at a stretch on Wells Fargo).

We still think -0.20% is more likely than +0.20% based purely on economic risks and the lack of any traction to get macro out of its current doldrums. Still, the equity markets are in decent shape on hopes that liquidity conditions remain accommodative (lack of a rate move for example was a boost). The FTSE has now returning 10.5% YTD and the S&P over 6%. The DAX has recovered to be just 2.3% lower this year.

Here’s to a good start to the month of October. Back again tomorrow.

Suki Mann

A 25-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 Credit Market Daily.