Ever since the ECB commenced buying tens of billions of sovereign and corporate bonds, it is undeniable that Europe’s economic picture brightened substantially, eliminating occasional flash crises such as Greece and Italy which had a contagious event on the rest of the Eurozone, and why not: after all there was a definitive backstop to all the risk – nothing bad was allowed to happen, or as Draghi said, any adverse outcomes would be fixed “whatever it takes.”
But in recent months Europe’s economic picture has turned decidedly dour, if not so much in the primary data where things are still stable, then certainly in manufacturing surveys, and especially for Europe’s economic dynamo, the export economy. As the chart below shows, PMI trends for new export orders have fallen notably in 2018 – and not just for Europe, but also for Japan and the US. This, according to BofA’s Barnaby Martin, “may point to less vibrant export activity across the world. For Europe, whether this is really the case, or just a reflection of €-strength earlier in the year, remains to be seen. But for now we think the economic data has not been convincing enough to ignite enough of a rally in European risk assets“
Which brings us to the next logical thought: could Europe be approaching a recession, especially if trade wars with the US cripple Europe’s exports which forms that backbone of the German economy, without which Europe is lost. Anecdotally, the following colorful snippet from Martin explains why a US-Europe trade war would really be Europe at war against itself.
If US-EU trade tensions escalate, we would view it as akin to pitting Europe vs. Europe. The US trade deficit with the EU-28 is far from homogenous. Germany exports cars to the US…but France doesn’t, and while Italy is a net exporter to the US, the Netherlands is a net importer. Therefore, growing trade tensions are likely to further fragment the Eurozone, just at a time when ECB QE is drawing to a close.
To be sure, Europe’s current growth trajectory remains far from a recession. According to BofA’s economist team, which recently took down their 2018 Eurozone growth outlook from 2.4% to 2.1%, partly marking-to-market given the weak Q1 momentum, they acknowledge the downside risks posed by Italy and trade tensions. At the same time, however, they calculate that “a trade war coupled with a confidence shock could push the US economy to the brink of recession.“
It’s not just trade however that is a defining risk for Europe’s highly “connected” economy: a far bigger risk is what happens to the ECB’s QE… and what, if anything will replace it?
As Martin explains in a note titled The “next” recession, “we worry that the ECB is ending QE…but nothing else is being instigated to take up the slack. In particular, fiscal stimulus is not on the cards in Europe, despite the positive effects of it being evident now in the US (see Q1 US earnings, for instance).”
This is demonstrated in the next chart which shows just how different the US and Europe are in regard to fiscal generosity vs austerity.
So what happens if the worst case scenario emerges and after several months, not only QE ends but European trade concerns are realized, and a recession becomes unavoidable?
This is where things get complicated, not so much for the economy itself, but for how such a slowdown would impact hundreds of billions of debt that exists largely thanks to the ECB’s QE, and which is currently on the cusp between investment grade and junk. Here is Martin:
The idea of the “next” Eurozone recession fills us with a lot of fear however. Not just because many central banks would be relatively constrained in their ability to cut rates after their big post-GFC easing, but more because of how disruptive it could possibly be to the Euro credit market.
As the BofA strategist explains, the disruption would manifest itself first and foremost in how Europe’s “QE years” have profoundly altered the structure of the Euro credit market, to wit:
“Not only, on the one side, have they encouraged the more credit-constrained issuers to embrace bond financing, but on the other side the strict eligibility rules of CSPP have motivated high-yield companies to deleverage and return to an IG-status, where possible.”
The outcome has been an unprecedented increase in BBB-rated debt to fund Europe’s recent growth, debt which however is now also Europe’s Achilles heel.
The net result of these two themes in Europe is depicted, starkly, in Chart 4. Since the beginning of 2015 (PSPP started in March ’15) the size of the BBB-rated non-financial sector has grown from €450bn to €755bn (66%). Conversely, the size of the Euro high-yield market has shrunk from €310bn to €285bn over this period.
As a result, this has left the non-financial BBB-market now 2.5x bigger than the high-yield market in Europe…a ratio not seen since before 2008.
Said otherwise, there is close to €800bn of BBB-rated non-financial bonds, but the HY market is just €285bn in size (as a reminder, the ECB is technically prohibited from purchasing junk bonds in the open market).
Martin then shows what has been behind this dramatic increase in the size of the Euro-denominated BBB market over the last few years: it is demonstrated in the next chart which breaks down the components of market growth: here, around €200bn of growth comes from debut BBB-rated issuers, or said otherwise, “QE drove debt costs so low that many issuers who had previously never raised debt joined the party…“
It is here that the impact of a recession would be most acute: should a Eurozone recession become a more plausible event down the line, then the prospect of negative rating migration would have overwhelming consequences for the credit market in Europe, as the “the potential for such a vast amount of Fallen Angels (BBBs being downgraded to high-yield) at a time when Euro high-yield bonds are shrinking would cause enormous ructions and indigestion in the market.”
Even in a best case scenario in which some BBB-rated issuers staved-off a downgrade with rights issues or emergency asset sales, the potential Fallen Angel quantum is still dramatic.
For reference, the largest expansion of ICE BofAML’s European Fallen Angel bond index was from €20bn to €110bn – but this took almost 7yrs to transpire (from September 2008 until April 2015). But in the “next” European recession, rating downgrades would not take 7yrs, in our view.
For the reductionists, there is a far simpler way to describe the above dynamic: the ECB’s punchbowl led to an unsustainable credit bubble, especially among investment grade companies that are on the cusp of a downgrade should a recession hit, which would cascade into the capital markets resulting in “enormous ructions and indigestion in the market.”
In this light, it is easy to see why BofA is “filled with a lot of fear” from what is coming, and why it’s conclusion is that “a Eurozone recession can’t (be allowed to) happen“
However, it is only a matter of time before one does hit, and it will be the fallen angels that are hit first. Which explains why there are already those who, like Oaktree and Horseman Capital, are preparing to capitalize on what we recently called the “$1 Trillion Opportunity In The Coming Bond Crash.”
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