Credit strategists are... bearullish, we guess Our broad US outlook for 2014 is that it represents an inversion of the situation from the start of last year: while the conditions for economic growth in the US now seem better than they were then, the prospects for debt and equity markets are much more complicated. It's easy to understand this flipped dynamic in equities. After a 30 per cent return in the S&P 500 last year, stocks are widely thought to be either fairly priced or perhaps a little overpriced, making it tough to know what happens next. Yet credit markets are more interesting and, as ever, more baffling. Two recent, interesting notes from credit strategists are good examples of why. They have differing views on what will happen to spreads this year, but both are pessimistic about fundamental credit conditions. Without endorsing or disputing either view, we excerpt from the notes below. The first is from Hans Lorenzen, Matt King & co at Citi writing about European credit (hat tip Tracy Alloway for alerting us to the note), though much of what they say is applicable to the US as well and chimes with an earlier note from their American counterparts: The best way to describe our sentiments on 2014 as a whole is that we are bullish - but for all the wrong reasons. Bullish, because we still believe that the extraordinary liquidity environment which has dominated the last four years will remain in place this year - despite tapering. Bullish, because we think that in the absence of attractive assets to buy, and of clear negative catalysts, investors will once again scour markets for ways to enhance return prospects. We think this will happen through the usual formula: more credit risk, more duration, more subordination, more illiquidity risk, more financial leverage and more synthetic leverage. The process of getting into those exposures will in itself tend to push spreads tighter, as reflected in our forecast. For the wrong reasons, because aside from our doubts about the foundations of much of the economic recovery itself, nearly all the factors that we would normally base our view on credit on seem to be pulling in the opposite direction: Credit fundamentals are deteriorating. Although the fragile European and global recovery should support earnings, we expect leverage to rise further as companies push shareholder value. Valuations are increasingly unattractive. Scored against 20 different fundamental metrics, credit spreads come in as "Tight" or "Very tight" on every single one of them at the moment. The yield offered by € IG corporate credit is in the 4th percentile looking at the last ten years - hardly a compelling case for investing if you look at credit from a total-return perspective. The marginal money is going elsewhere. Judging by our survey, inflows into corporate credit have been on a falling trend for 18 months and are now close to neutral at a five-year low. This weakens the technical that has so often left the credit market almost impervious to negative headlines in recent years. Market composition is deteriorating. We think the European credit market should see a record volume (~€90bn) of subordinated debt issuance next year. While some of that (the AT1 issuance) will remain outside the indices for now, the market will still have to absorb a lot of additional risk. And to top it off, positioning in the credit market is very different. The rush into beta may have further to go, but already the rally we have seen since September has created a vulnerability through higher-beta exposure in the market. We reckon that it is at least comparable to the one that was exposed by the Fed's change in tone on tapering in May. We'd argue that markets may be driven by a variant of the Greater Fool's Theory, where the underlying rationale for many would in essence be: "I don't like credit here, but I don't like other assets very much either (other than, perhaps, equities). I don't see what turns the market any time soon and I can't afford to sit and wait for a better entry point, especially while central banks are backstopping everything. I'll have to take more risk and then sell to someone else when I see a trigger ahead. Worst case, I'll be in the same boat as everybody else. We are not arguing that this is irrational - on the contrary, for individual investors whose performance is tracked on a monthly, weekly or daily basis, this argument seems entirely rational - especially against the perception that central banks can no more afford to let the prevailing equilibrium slip today than they could in 2009. But the sum of that individual rationality is a market with a very obvious vulnerability. When no one sees an immediate risk of losing, when positions get ever longer and when valuations are stretched further and further as a result, less and less is needed to eventually topple the consensus. Longer-term, it is a recipe for breeding black swans. So the inherent challenge is to predict how long the Greater Fool's game goes on. As we saw from 2004-07, spreads can underestimate the subsequent cycle for a long time before correcting. And in our central scenario 2014 is still a ramp-up year. The imbalances do not yet seem glaring enough and the macro agenda, ex ante at least, is the lightest that we have or are likely to see for years. ... And included in their section on what there is to like for near-term credit is this: Still too much money and not enough assets to buy: To be frank, we don't think there's any macro risk premium left in credit spreads now. But what matters here is that in the absence of a tangible trigger investors are still being enticed into taking more risk by the global central banks. In all the fuss about the impact of tapering last year, we think that much of the market lost sight of the bigger picture: Assume linear tapering from January to September and we estimate that the Fed will still do more than $400bn of QE this year - that's about 70% of the entire QE II programme (Figure 25). Moreover, remember what is happening in a global context. In 2013, the ECB (largely involuntarily) ended up reducing excess liquidity substantially though LTRO repayments. While it remains to be seen what the ECB will do this year, it is unlikely that it will cause a similar reduction in global liquidity this year. Moreover, the BoJ of Japan currently seems more likely to expand the pace of QE than to reduce it. In aggregate, combining the net liquidity injections by the Fed, the ECB and the BoJ together, the picture looks little changed from 2013 (Figure 26). The implication is that the universe of securities across asset classes that investors will be able to buy still won't be growing nearly fast enough to keep up with likely demand in 2014. Our proxy for the net growth in the investible universe of securities (the red line in Figure 27) combines net issuance of securities across asset classes for Europe, the US and Japan, from which we have subtracted central bank interventions. It shows that the annual growth in the supply side of the securities markets has effectively declined from $3-4tn to between $1-1.5tn - a two-thirds drop - over the last few years. Based on our forecasts for issuance and central bank interventions next year, it is unlikely that the net issuance of securities returns to anything like the "natural" rate. Coupled with solid demand for securities as a result of low returns on risk-free deposits, we think the rally in recent years is to a large extent driven by an enormous global supply-demand imbalance. So to us, the likelihood that the net supply of securities will remain almost as constrained in 2014 is a key reason to be comparatively bullish in the central scenario - also on credit. Here's a shorter excerpt from a note by Barclays strategists on US credit, recommending that investors move some money to cash when spreads drop beneath a certain cutoff: The sharp rally at the end of 2013 left much of the credit market at multi-year tights (Figure 2). As we discussed in Global Credit Outlook 2014, we believe overall upside in 2014 will be limited, with excess returns unlikely to be much more than carry. Given the current level of spreads, particularly in the investment grade market, we believe effective cash management could be one way to generate outperformance. In this week's focus article, we examine the historical benefit of holding cash when investment grade spreads are below 110bp. We find that such a strategy would have resulted in 12bp of annual outperformance since 1994. Although 12bp is modest and holding 100% cash is not realistic, the exercise is informative in that it shows that we are close to levels where de-risking has historically made sense. Both investment grade (IG) and high yield (HY) spreads are now tighter than at any point since 2007, rallying through December and into 2014. But with spreads approaching the tighter end of their historical ranges (IG at the 30th percentile, HY near the 20th), we think it is timely to consider at what point investors should think about being less invested. This is compounded, at least for IG, by the possibility that spreads may be nearing a floor. ... While spreads are still much wider than pre-crisis tights, we believe the room for further tightening is limited given structural changes to the market, including a worse liquidity environment and wider financial spreads compared with before the crisis. More in the usual place.