“What is going on?”, Deutsche Bank asks, in the bank’s latest European equity strategy snapshot.
Investors, Deutsche says, can’t seem to figure out why it is that European equities have plunged by some 20% since peaking in November. The usual suspects are trotted out (China, renewed concerns about NPLs, and the shocking realization that central bankers’ are more impotent than they are omnipotent) but the real problem, the bank says, is threefold: 1) there’s a very real risk that China finally throws in the towel on the whole “controlled,” “orderly” devaluation thing in the face of worsening capital flight and simply moves to a float to relieve the pressure, 2) global growth is stuck in the doldrums, and 3) the US is about to enter a default cycle thanks to the fact that the country’s uneconomic energy producers are all about to go bankrupt in the face of shrinking borrowing bases and a HY primary market that is suddenly slammed shut.
Remember, this is a collection of companies who are and pretty much always have been insolvent. The whole damn space is cash flow negative, which means if someone doesn’t step in to plug the funding gap, the music stops. No more drilling. No more pumping. No more coupon payments. Game over.
Until now, Wall Street has stepped up to the plate with cheap cash and by providing access to what until recently were wide open capital markets. Now, all that’s changed. There’s not enough yield in the world to entice investors to buy new issuance from US HY energy producers and the revolver raids that started in October will likely continue in April.
Barring some sort of dramatic turnaround in oil prices, the defaults are coming, and as Deutsche goes on to note, once the speculative default rate hits 4%, it’s almost guaranteed to shoot up to 10%. Although we’re only at 3% now, spreads are already at levels consistent with a speculative default rate of 5%.
Have a look at the following two charts which suggest that the US is indeed entering a default cycle and if history is any guide, it’s about to get very messy, very quickly.
* * *
From Deutsche Bank
Over the past 100 years, when defaults have risen above 4%, they have typically continued to rise close to 10% (i.e. a full default cycle). This is because of the tendency for credit stress to become self-fuelling: a rise in expected defaults pushes up financing costs, which tips some marginal borrowers over the edge, further increasing defaults and so on. With non-energy spreads rising in line with overall spreads and issuance down sharply, this process seems to be under way (and explains the sharp underperformance by banks).