Lately UBS, which just announced its latest ugly quarter in which the ultra-wealthy client dependent bank saw $3.3 billion in outflows from its all important wealth-management business, has been increasingly dour on the future, whether it is warning to "Buy Gold" As Equities “Rolling Over” or explaining "How The Investment Grade Dominos Will Fall." Today, UBS' chief global credit strategist Matthew Mish takes on the pleasant topic of predicting what the next imploding "energy-like" sector in credit markets, which is particularly relevant after today's historic downgrade of several energy names which until last year seemed unshakable.
Here is his response:
What's the next 'energy' sector in credit markets?
Our recent conversations have led to investors' increasingly scrutinizing our world view, demanding to better understand the risks inherent in the US corporate and broader credit markets; i.e., proverbially what is the next 'energy sector'. While that question is indeed challenging, we'll do our best to paint a straightforward answer. To reiterate, our focus in this piece is on US corporate credit and, more broadly, US credit conditions; we will not discuss dynamics outside our own borders. And it is indeed possible that there may not be another 'energy' story, but rather a series of smaller episodic stresses that play out across credit segments.
The hallmarks of most asset price booms and busts are grounded in irrational and aggressive future return expectations, which fuel a significant easing of lending standards and debt growth followed by a reversal of both conditions. Historically, one clear harbinger of future stresses has been debt growth. Those industries with the most aggressive credit growth in prior cycles (e.g., telecommunications in the '90s, finance and autos in the 00's, Figure 1) tend to ultimately cause the most pain for investors. Some would say this is an obvious and inherent flaw in the structure of corporate debt markets; that is to say those sectors that issue the most debt naturally grow larger in benchmark HY funds, and ultimately – when the credit regime turns – their investors have too much exposure to industries and issuers with substantial gearing. The result is a lower risk appetite, tighter lending conditions and deleveraging. But such is the largely indexed world we live in.
We believe the lower quality (e.g., triple C) segment of the US HY market fits this thesis to a 'T', and remains a unique risk in this cycle given the factors of Fed QE and regulation. However, some would argue this sector has re-priced considerably and liquidity is challenging to manoeuvre positions (i.e., it's too late).
The other areas we will highlight have not re-priced to the same extent, so the risk is we are early (or simply wrong) – but this thesis is what many investors are seeking. In US high yield, excluding energy E&P the next largest industries experiencing debt growth in this cycle are technology and cable. In US leveraged loans, we have seen a similar trend in technology specifically. However, in both cases the relative growth is not as extreme as that witnessed in energy. In US high grade, the picture changes with outliers excluding gas pipelines in the REIT and pharmaceutical industries.
The latest Fed SLOOS offers some key insights in this regard. First, banks indicated that their lending standards for commercial real estate (CRE) loans of all types tightened in Q4, with significant fractions reporting tightening in multifamily (MF) and moderate fractions reporting tightening for construction/land development (CLD) loans. Second, banks were asked about longer term expectations for lending conditions through 2016: significant fractions of banks stated they expect to tighten lending standards on MF and CLD loans, while a moderate fraction expected tightening on nonfarm nonresidential (NFNR) loans. And third, on the outlook for loan performance in 2016, a significant fraction reported that they expect rising delinquencies and charge-offs for all categories of C&I loans.
In short, while there may not be another 'energy' sector this cycle, our proverbial list of candidates includes lower quality high yield (ex-commodities) and commercial real estate (CRE). More broadly, the OCC's own examiners would also likely add asset-backed and auto loans to the list. The stark conclusions these credit officers draw with respect to the massive easing of credit standards due to competitive pressures seems clear enough – but unfortunately they seem to largely fall on deaf ears.