Europe over US in DM HY
Crossing a political Rubicon. The stimulus agreed by the European Union (EU) to be funded by common borrowing is a landmark deal; a step towards fiscal integration to complement the monetary union (and partial banking union) that already exists in the region. The breaking of new ground in fiscal policy coordination shifts outcomes away from the extreme left tail risks concerning the dissolution of the EU, frequently championed by Eurosceptic left- and right-wing populists of member nations. Diminishing risks of undesirable splintering from weaker states give a much-needed sentiment boost to consumer and commercial confidence in the region’s recovery.
The virtuous cycle of viral containment. On the medical front, Europe has demonstrated more effective curve flattening over their Developed Markets (DM) counterpart across the Atlantic in the process of continued reopening of the various member economies. This inspires confidence for further normative reversion; prolonged success could lead to the formation of intra-European travel bubbles which would further expand economic activity. Notably, the Eurozone composite purchasing managers’ index (PMI) had swung back into expansionary territory by July with a print of 54.8, reflecting the positive change in business sentiment.
While European Investment Grade (IG) spreads have reflected this positive shift in expectations, European HY spreads are still pricing in PMIs in contractionary territory, which suggests that upside remains for taking more credit risk in Europe.
Figure 1: European HY market still pricing in contraction while IG has firmly priced in expansion
Data ranges from 2012-2020
Source: Bloomberg, DBS
Effective viral containment is a prerequisite for confidence in economic reopening. While both the US and Europe are slowly reopening their economies, Europe is the likelier of the two to see a quicker recovery at this juncture. Referencing Sweden’s unique strategy of not implementing a full-scale lockdown, the country did not reap the benefits of more economic activity despite having a far higher death toll compared to their Scandinavian neighbours. Citizens were simply not confident enough to participate in ordinary levels of economic engagement while the threat of the virus remained.
As such, the speed of reopening is effective insofar as the population is confident enough in viral containment to resume activity – no one is safe till everyone is safe, so the numbers do matter.
Figure 2: Stark divergence in efficacy of viral curve flattening between US and Europe
Source: ourworldindata.org, DBS
US banks highlight an early warning signal. Uncertainty on the path of recovery in the US could be a possible reason why lending standards in the US have conversely tightened – together with a surge in loan-loss provisions – despite a slew of unprecedented monetary stimulus from the Federal Reserve. This continues to pose a hinderance to monetary policy transmission, as the large increase in excess reserves by the Fed was intended to flow to the real economy through the conduit of the banking system.
The Commercial & Industrial (C&I) Loan Standards reading within the Fed Senior Loan Officers Survey published in early August is a good leading indicator of HY defaults one year in advance. This suggests that the US HY trailing 12-month default rate is likely to reach double-digits by mid-2021 – close to but slightly under the peak in 2008.
Figure 3: Rising share of US banks reporting tighter lending standards – a precursor to higher default rates
Source: Federal Reserve Board, Moody’s, DBS
European HY historical and expected default rates comparatively benign. Looking at historical and projected default trends, European HY default rate is expected to be a notable 6% lower (Figure 4) than US HY. This could be attributable to a couple of factors:
Policy efficacy: Levels of debt guarantees and liquidity support measures for large corporations – including those HY-rated – in European jurisdictions (Germany, France, Italy etc) have been stronger and broader. The Fed’s Main Street Lending Program on the other hand, with max loan sizes ranging USD25-200m and leverage constraints of 4-6x, leaves the most at-risk borrowers ineligible.
- Banking system reliance: The Euro Area has only c.12% of non-financial corporate debt raised in bond markets, while the US has c.65%. European companies rely more on banks for funding; banks have better access to information and can show more flexibility in renegotiating terms when borrowers experience financial distress compared to bondholders.
European HY absolute yields trading close to US HY. Given the more contained default risks in European vs US HY, the market is currently pricing in merely a 40 bps premium in absolute yields of US HY (c.5.3%) over European HY (c.4.9%) – driven by the Fed’s direct participation in HY markets. Put in perspective, the average premium in the last five years was more than 200 bps. The yield differential – currently at three-sigma levels – indicates that the market could see some mean reversion in the medium term (Figure 5).
In summary, European HY presents an increasingly strong case for income generation in DM HY, given a mix of positive catalysts and lower expected defaults. We continue to expect that the low yield environment will drive support for HY as an asset class, and consider that European HY will offer diversification benefits of DM characteristics in addition to our long-standing positive view on Asia HY (please refer to “Global Credit 3Q20: Leading the recovery”, 6 Jul 2020).
Figure 4: European HY trailing and forecast default rate more muted compared to US HY
Source: Moody’s, DBS
Figure 5: European HY discount to US HY in absolute yield terms at c.3σ lows – around 40 bps compared to 5-yr average of >200 bps
Source: Bloomberg, DBS
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