Vident: Battening Down The Hatches

December 17, 2015

[The following "ETF Issuer Perspective" is sponsored by Vident.]

Screaming, crying, perfect storms
I could make all the YTD tables turn
HY garden filled with defaults
Keep you second guessing like oh my god
Who is she? I get drunk on ZIR policy

So it's gonna be forever
Or it's gonna go down in flames
You can tell me when it's over
If the Dow high was worth the pain
Got a long list of excuses
For not having to raise the rates

[Chorus]
'Cause investors are yield hungry and reckless
We'll take this way too far and leave you spread-less
Or with a nasty scar
Got a long list of excuses
For not having to raise the rates

They'll tell you I'm insane
But I got a zero-bound baby
And you love the game …

-—End of QE by Janet Yellen channeled via Taylor Swift's Blank Space

At the end of 2015, after an unprecedented easy monetary policy of the last eight years, the U.S. Federal Reserve led by Dr. Janet Yellen will tell investors if "it's gonna be forever" or if it is the end of QE and the beginning of a tightening cycle. Investors will have to wait and see if it's gonna go down in flames" and leave a nasty scar for yield-hungry yield chasers.

Globally we have seen many scars—especially in the emerging markets—both in commodity-driven markets like Brazil, Colombia and geopolitically driven markets like Russia, Turkey and China, to name a few. Closer to home, energy stocks are down more than 20%. And the energy high-yield credit sector has seen major defaults. Has the credit cycle turned already, ahead of the Fed?

What's In A Credit Cycle?
A credit cycle may or may not neatly coincide with a general economic or monetary cycle, and might not affect all economic sectors at the same time to the same degree. But at times, there are unanticipated ripple effects. An overleveraged energy company may default, causing strain in the local banking, commercial and residential real estate or consumer discretionary (e.g., retail) sectors. It's hard to know even all the "known unknowns" in a $15+ trillion U.S. economy, let alone in the global one. How the "dots will be connected" in a global economy will be revealed once the credit cycle turns. Or, as Buffett says, when the tide goes out, we find out who was swimming naked."

High-Yield Spreads1 Bottom Already?

In our modern post-central-bank credit-driven economy, financial assets are driven by supply of credit. The credit cycle waxes and wanes with monetary conditions/policy and is interconnected with the economic cycle over time, but is not perfectly synced—meaning its amplitude, phases and wavelengths are different from the economic cycle.2

Currently it feels like we are in the late-cycle phase of the credit cycle. Generally in a late cycle, defaults are low (currently 2% ex-energy in HY), profit margins peak/shrink, M&A goes into high gear ($4+ trillion in 2015, surpassing the past peak of 2007) and cash portions of earnings or cash positions decrease. For most fixed-income sectors, the cycle has been benign, but is marching into the late-cycle phase.

A particularly worrisome credit sector is EM corporates, where outstanding debt has more than doubled, from less than 40% of GDP in 2009 to over 75%. Defaults in emerging markets over the last 12 months were at 3.8% versus 2.5% in the U.S.3

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