Two weeks ago, we issued a “Friday chart challenge” in which we showed you the following graphic:
The point, of course, was to demonstrate that the market is pricing in less relative default risk for HY energy than at any other time since late 2014. That of course is absurd given the global deflationary supply glut and a geopolitical chessboard onto which the eternal ideological war between Tehran and Riyadh has spilled in the form of a black gold production race.
Today we bring you a new graphic which speaks to the same point. Behold:
So basically what you’re looking at there is the same grey shaded area from the first graph only this time it’s the red line on top of the spread between Citi’s HY Energy index and oil. See that epic divergence there on the right-hand side? That’s two sides of the same coin. You’ve got the market pricing in minimal relative default risk for HY energy and you’ve got the spread between the HY Energy index and WTI spiking to an all-time high. Here’s Bloomberg with some additional color:
“‘That portion of the high-yield market especially, it looks a little rich with crude at $40," a barrel, Brad Rogoff, head of global credit strategy research at Barclays Capital, said Monday on Bloomberg TV. "If we drop below, you’ve probably got some downside there.’"
“High-yield energy bonds are on track for their best returns since 2009, with oil recovering from a 13-year low of $26.21 a barrel in February. After rising to $51.23 in June, crude dipped back under $40 on Monday. With that drop, the correlation between speculative-grade bonds and the oil price is at its weakest level since at least 2010.”
(Chart: Bloomberg)
Essentially, the market just isn’t pricing this in. We’ve outlined all kinds of reasons why there’s probably more downside for crude and yet HY energy is acting like that one bounce from $27 to $50 solved everything - even though US shale was FCF negative to begin with! Here’s BofAML’s latest on the space:
“The first full week of earnings is behind us with the majority of the reporting schedule being dominated by oilfield services companies. Although several bellwethers have called the bottom as customer sentiment is improving, most companies remain cautious. Ultimately, the pace of a full recovery is reliant upon a stabilization of crude oil at $50+/bbl. As oil grinded lower for the 9th consecutive session, hitting a 3-month low, investors are reminded that a rebound in services could take longer than expected.”
And here’s what the aforementioned Brad Rogoff had to say two days ago:
“Oil prices, one of the key drivers of valuations, especially in the high yield market, dropped another 7% this week and are now about $10 lower than their early-June highs. Over the past few weeks, the High Yield Index has outperformed the high yield-oil relationship from earlier in the year significantly; that said, if oil continues to decline, we expect it to begin weighing on valuations. The recent strength in credit markets can be attributed in large part to strong demand from international investors. The nature of the demand means that it is difficult to predict, but it has driven valuations to extremes in some segments of the market, which could come under meaningful pressure if the demand technical abates.”
(Chart: Barclays)
We’ve discussed that “technical” here before.
The bottom line is that while there’s no such thing as a “mispriced asset” (the price just is the price), there’s such a thing as “misallocations,” and the hunt for yield has speculative grade energy exceptionally rich right now. Trade accordingly.