Yesterday Paramount Pictures released their trailer for a forthcoming film starring Christian Bale, Brad Pitt, Ryan Gosling and Steve Carell. Any initial presumption of the film genre based on this hardy line-up would be wrong. The film is in fact an adaptation of Michael Lewis’s financial biopic “The Big Short” and unravels the story of the US housing bubble and subsequent Global Financial Crisis through the lenses of some curious people who were betting against it. Although the film’s casting might slightly overstate the typical handsomeness of your average financial sector worker, if anything like the paperback, it will certainly highlight the exuberance and liberal lending ethos leading up to the GFC. But poor lending practices weren’t just constrained to the housing market, and warning signals weren’t only found in the delinquency statistics of collateralised mortgage obligations.
Back in September 2006 we began publishing one of our models based on a relationship between the US yield curve (Fed Funds - UST 10yr) and high yield spreads. The model showed that every time in the past couple of decades that these points in the yield curve were inverted an impending recession was likely and high yield spreads would typically widen. Along with other analysis this made us perceive holding sub-investment grade as dangerous and higher quality investment grade as particularly attractive. The extensive use of leverage and credit derivatives abated this eventuality for a further year meaning that when they did eventually snap, high yield spreads went from 250 over Treasuries to 2000 over. Those that didn’t follow a similar investment process or act on these warning signals took a big hit, but many haven’t learnt from the mistakes that were made just 8 years ago.
Although this particular model is less foretelling now, given the other influences on the US curve, there are have been other clear signs that overreaching for yield in emerging markets was an unwise and inadequately compensated risk; the recent performance of examples like Brazil are proof of this. The Brazilian real is down over a third year to date and their 5yr CDS currently trades at around 500bps, around 100bps higher than that of Lebanon. Although this particular ranking is questionable it does exhibit how quickly sentiment can move to align with fundamentals when it finally does happen. We have been warning against such a potential move in lower grade emerging market debt and currencies for a while and increased our target portfolio average credit rating to A3 back in mid-2014. However even after such a sell-off we still identify better value elsewhere and our top down analysis still prefers a higher average credit rating.