While it may be the “week from hell”, there is one specific event that stands out to BofA’s credit team: since the outlook for financial markets is mostly about the transition of global monetary policies from QE to QT, and since as discussed here on countless occasions over the past year, the adverse effects of US QT are mitigated by ECB and BOJ QE (and NIRP), to BofA this makes the ECB meeting on Thursday the most important of many events this week, as Peter Praet has confirmed the ECB will be discussing how and when to end QE.
But while economists are increasingly confident that Draghi will end QE in December, what do investors think and are they panicking just yet?
Well, as BofA’s Barnaby Martin writes in his latest, June, credit investor survey, there is an underlying level of comfort with Draghi “protecting” credit markets over the months ahead one which fades as the year approaches its end. Furthermore, what Draghi says on Thursday will be pivotal for corporate bonds. And, if Italian politics conspired to curtail the ECB’s flexibility (and desire) to support markets, then credit spreads looks vulnerable to a big negative sentiment shift. In other words, the risks now appear highly skewed to the downside.
The potential for a sudden puke on the ECB announcement is the bad news. The good news is that investor positioning appears to already be markedly lighter. In fact, Martin notes, “Euro credit clients are short for the first time since September-2011, and especially so now in financials.”
According to BofA, such an increasingly bearish backdrop “will help keep disorderly widening moves in credit at bay, given that Italy is expected to be a continued big drag on the market.”
But going back to the risk, it is hardly a surprise that as the chart below shows, the majority of high grade and high yield investors (33% and 50% respectively) expect the end of QE to be the biggest threat for peripheral credit going forward. This is closely followed by “populism” by 30% for high grade investors.
Which of course is a bit of a paradox, because while the ECB will sooner or later have to taper as it is running out of German bonds to buy, the populists have been clamoring that the ECB is punishing them specifically, even though the central bank will soon have no choice but to punish everyone equally. The irony is that of all European credits, it is Italy that is most mispriced, so when the ECB’s training wheels fall off, watch out populists if the population equates the economic and market plunge that follows with the League/5-Star policies.
Still, it is hardly rocket science that without the biggest price-indiscriminate buyer of assets in the past 4 years, the ECB, that investors would be nervous.
But wait, it gets better: according to Martin, without the safety blanket of QE, investors appear confused as to which way to look, and according to BofA’s “Wall of Worry”, the bank’s clients “seem to be almost equally concerned about every risk at present, without any clear stand-outs.” Still, there are distinct worry clusters:
Relatively, though, the themes that have become a greater concern over the last few months are Market Liquidity Evaporating, Trade Wars and Populism. One bright spot is that investors expect a return to pristine balance sheets by companies, and the end of shareholder-friendly activity.
Digging into the top few fears, at the top of the Wall of Worry for high grade investors are: “Bubbles in Credit”, and “Populism in Politics”, followed by “Quantitative Failure” and “Market Liquidity Evaporates”. High yield investors are also primarily concerned about “bubbles in credit”.
And speaking of Italy, when BofA asked investors across high grade and high yield markets (combined answers), where 10yr BTP vs. bund spreads will be at the end of the year, the most bearish are the Germans. On the other side, the most bullish are UK investors, French clients and, very interestingly, Italian investors. A few more days of shorts getting mega squeezed like today, and the Italians may not be optimistic enough.
Stepping away from the ECB and Italy, Martin asked an interesting question which shows the increasingly gloomy outlook by junk bond investors and the – still – relative detachment of IG investors. Specifically, high grade investors seem to be far more bullish on the European economy, as they expect the next recession to come in 2020 or after (74% of investors). At the same time, the high yield market sees the risk of a European recession being sooner. More see it in either the second half of 2019, or in 2020.
Finally, closing on a somewhat more optimistic note, BofA asked its credit client base what they saw as the catalyst for a rally. Not surprisingly, with the ECB having become the price setter for all asset classes in the world in recent years, the prevailing answer from the majority of credit investors (32% of IG and 40% of high yield) was that the most supportive catalyst for a market rally could be the ECB delaying the end of QE. In distant seconds was Franco-Germany progress on Eurozone integration and a weaker Euro could also help drive a rebound in spreads.