What’s Credit Telling Us Now?

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One of the most reliable risk indicators in our 21 Lehman Systemic Index is the rate of change found in credit spread contagion.

If a fire is spreading quickly, it’s far more deadly.  As we often share with clients, rule number one – credit leads equities.  Since the financial crisis, nearly every significant drawdown in the stock market has witnessed meaningful (accelerated) credit deterioration in the weeks before.  Our model measures this rate of change and quantifies its significance. 

When compared to U.S. Treasuries – junk bond yield spreads have widened nearly 70 basis points since late February, reversing a long run of positive “risk on” spread compression.  Looking back over the last seven years, the S&P 500 declined anywhere from 3.8% to 20.3% in the 11 plus examples of this contagion.

Looking back over the last 10 years, U.S. high yield finished Q1 in its 94 percentile in terms of expensiveness, now that’s rich.

CCC Love

Even worse, the junk of the junk smells like six day old fish but this month has a market embrace resembling a young bride holding on to fresh flowers.

Central Bank Induced Yield Chase, Created a Toxic Cocktail

If we Look at the CCC Rated Bond Universe

Annualized Returns

2008-2017:  16.8%
1996-2008: 1.4%

Bear Traps Report, Bloomberg data

CCC is a very speculative grade assigned to a debt obligation by a rating agency. Such a rating indicates default or considerable doubt that interest will be paid or principal repaid.

Moral Hazard in Energy Lending

Covenant standards in energy lending are at all time lows.  The Bear Traps Report Team reviewed 15 oil and gas producers that have used 72%+ of their borrowing-base credit lines during spring redeterminations by lenders.

The Most Leveraged

Credit-line use exceeds 85% Abraxas Petroleum, Approach Resources, Mid-Con Energy Partners and Rex Energy.

Of course, crude oil price curves declining through 2021 may influence bank decisions on cutting credit lines.

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High Yield vs. Investment Grade Bond Spread

IG v HYHigh yield has underperformed investment grade bonds by 25bps over the last 30 days.

2017’s “Junk” Bond Prices

% of Bond’s Market Value

100-115: 73%
95-100: 15%
Below 95: 12%

Bloomberg TRACE, Citi Index data

It’s nothing short of crack smoking insanity.  This month over 88% of high yield bonds were trading north of 95 cents on the dollar. Bloomberg / Bear Traps Report data.

High Yield Gross Leverage

2017: 4.6x
2016: 4.4x
2015: 4.2x
2014: 4.0x
2013: 3.7x
2012: 3.2x
2011: 3.9x
2010: 4.5x
2009: 4.4x
2008: 4.3x (Credit Crisis)
2007: 4.1x
2006: 3.6x
2005: 3.1x
2004: 4.1x
2003: 4.5x (Credit Crisis)

Bloomberg, Bear Traps Report Data, Capital IQ

We’re sorry, the high yield market is not on crack, it’s actually smoking crystal meth.

Total Leveraged Debt Outstanding*

2017: $2.5T
2007: $1.2T
1997: $310B

*subordinated bonds high yield, senior secured high yield bonds, senior unsecured bonds, first lien bank debt, second lien bank debt

Bloomberg, Barclays Credit Agg

Outflows

U.S. corporate high-yield funds posted $248.5m of outflows for the week ended March 29 after seeing an inflow of $736m last week, according to Lipper US Fund Flows data released this week.

Corporate investment grade funds saw inflows fall to $3.97b from $5.24b the week prior.

Investments in fixed-income exchange-traded funds declined 80 percent in the past week. Inflows to ETFs that invest in corporate bonds slowed and high-yield funds saw outflows.

Inflows to U.S.-listed bond ETFs totaled $1.14 billion in the week ended March 28, compared with $5.75 billion in the previous period, according to data compiled by Bloomberg.

Our Larry McDonald ran a $600m high yield and distressed credit business at Lehman Brothers, and is the NY Times bestselling author of a Colossal Failure of Common Sense.

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Earnings Season, How High is the Bar?

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Q1 Earnings Season

We’re already through the first quarter of 2017, can you believe it?  More importantly, how high in the bar for earnings seasons?

S&P 500 Earnings Expectations from Wall St.

2018 Street Consensus: $148.10
2017 Street Consensus: $131.45
2016 Operating Earnings: $106.45
2016 GAAP, Real Earnings: $95.35

The Road Ahead

Tax reform legislation climbs a far different mountain than the health bill. In December, we recommended clients overweight U.S. Treasuries, Utilities and Consumer Staples with a focus on “the high probability of political fumbles in Washington.”

Wall St. is Heavily Bought in to Tax Reform’s Success

We noted in December in our Bear Traps Reports, the difficulty congressional Republicans have had in reaching consensus on the health legislation can very easily lead to a pullback from their lofty ambitions on tax reform. Bottom line: the more extreme reform ingredients of the House Republican plan on tax reform are more at risk today.   Hot topics like the border adjustment and interest expense provisions that make up the destination based cash flow tax (DBCFT), will have far more uphill battle passing in an environment where near-unanimous support in the Senate will be necessary.

Expectations from Wall St., Numbers You Need to Know
 
Tax Reform = S&P Earnings Boost Corp*
 
Earnings Premium: New Corporate Tax Bracket vs Earnings Addition to S&P 500 from Tax Reform

32% v 0% (earnings boost)

30% v +3.5% (earnings boost)

25% v +6.5% (earnings boost)

20% v +9.5% (earnings boost)

15% v +12.5% (earnings boost)

Bear Traps Report Data

*This is on top of the Street’s assumed 14% earnings growth based on economic, stock buy back and dividend payout forecasts.

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S&P 500 Earnings

2017: $142*
2016: $116**

*Street’s forecast including successful tax reform
**Actual latest year (trailing four quarters to December 2016) GAAP earnings was $95.35,  latest year “operating” earnings (removes “unusual” items) was $106.45 per Bear Traps and Bloomberg.

 S&P 500 Twelve Month Forward Earnings Per Share Estimate

2017: $134.50
2016: $126.75
2015: $129.90
2014: $131.20

The forward 12-month P/E ratio for the S&P 500 is 17.5. This P/E ratio is based on Wednesday’s closing price (2348.45) and forward 12-month EPS estimate ($134.50).  Of the 111 companies that have issued EPS guidance for the first quarter of 2017, 79 have issued negative EPS guidance and 32 have issued positive EPS guidance.- Factset

As you can see, there’s 200-250 S&P handles tied to tax reform’s MEANINGFUL success.  Without the “expected” earning growth from tax reform, the current 18 PE on the S&P is far higher, well above 20 in our view.

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Wall St’s S&P 500 Targets for 2017

Best Case with Full Fiscal Policy Option: 2810*
Base Case with Partial Fiscal Policy Option: 2510
Worst Case with No Fiscal Policy Execution: 2090**
S&P 500 Today: 2343

We went through 12 different research reports from Wall St’s analysts, these are their best and worst case fiscal policy scenarios.

**Assumes no fiscal policy action (tax reform, repatriation, infrastructure) and a reversion to the mean in near record high CEO, small business and consumer confidence.

*Assumes full fiscal policy execution over the next 12 months (tax reform, repatriation, infrastructure, deregulation).

S&P 500 Sales Growth

2012-2016: 1.9%
2003-2007: 7.5%
1995-1999: 7.2%

Factset, Barclays

On the positive side, you can see why markets are so pumped up on Trump.  Sales growth found while looking at S&P 500 companies only grew at 1.9% during the mature years of the Obama economic recovery.  This data is well below normal levels and speaks to substantial upside if “animal spirits” are fully embraced in the years to come.

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