Tuesday, May 19th, 2015

Rehearsal Time in Financials

We will shortly be launching two new reports which look at the US credit markets on a sector basis, following the same architecture as our equity sector reports – except that there is no separate Small Cap “sector”. These reports will be split into investment grade and high yield, using standard definitions. Ordinarily we would not discuss the conclusions of the research until after the formal launch, but we are going to break this rule because (a) the launch is imminent and (b) there is an important message related to the behaviour of government bond markets over the last month.

In every developed country there has been a sharp increase in 10-year yields over the last month – strong enough to break the downtrends which had lasted for over a year, and to cause the slope of the yield curve to steepen dramatically. There are any number of plausible explanations, none of which really explain why the sell-off started four weeks ago, rather four weeks previously, or four weeks from now. However we are interested in the consequences, because we can observe a common theme in US credit markets and in almost every equity region.

A steep yield curve in the bond market normally indicates that banks will be able to widen their margins, assuming that their loan book has a longer duration than their deposit base, which is normally the case. Although there may be time lags when it comes to repricing the loan-book, this relationship is well understood by investors and is normally reflected in securities prices without much delay. Over the last four weeks the ranking of the Financials sector has clearly improved in almost every report. The biggest improvement comes in the US Investment Grade report, where it has gone from #8 (out of 10) to #2 and the recommendation has gone from underweight to overweight. In High Yield, the sector has gone from #3 to #1 over the same period and has significantly improved its lead over the #2 sector which is Utilities. In the US Equity report the sector has gone from #6 (excluding Small Caps) to #4.

So far we have only talked about the US, but most other government bond markets have experienced a similar increase in yields. In Japanese equities the Financials sector is now ranked #4 (up from #7 four weeks ago). In the UK it is ranked #4 (up from #6) but in the Eurozone it is stuck at #8, even though the recommended weight has increased slightly. It would be truly remarkable if the Eurozone Financials sector could outperform while Greece was on the verge of default. But the real point is that the ECB has already said that it will maintain or increase the scale of QE, hence there is little prospect of a sustained increase in the slope of the Eurozone yield curve.

If Greece does default, it is likely that yield curves everywhere would flatten at the onset of the crisis. But afterwards, assuming that the world does not end, we may find that yield curves outside the Eurozone continue to steepen and the Financials sector starts to outperform in most equity regions and in most credit markets. We think what has happened over the last four weeks could well be a rehearsal for one of the most important trades in Q3.

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