08 May 2018
One of the models we run in the Fixed Income Tactical Quant team is the Credit Cycle Model (CCM). This model predicts where we are in the credit cycle and recommends a credit beta position - whether we should be long or short the market. To derive this, we use a mix of fundamental indicators such as profitability and leverage as well as market based indicators from across different asset classes. One interesting development recently is the discrepancy between the European and US high yield (HY) versions of our CCM. The US HY model remains bullish whilst the European HY model has moved into recommending a small short position. The main driver of this differential is the distinct difference in leverage between the two markets.
The chart below shows one year forward net debt to earnings before interest, tax, depreciation and amortisation (EBITDA, adjusted for pension expense and operational leases). We know that leverage in the corporate market is high in historical terms and we can see it is far above 2009 highs. What is perhaps more interesting is the recent divergence. In America, we have seen substantial leverage reduction since 2016, moving from over 4x to around 3.5x. Leverage had been remarkably stable in Europe since 2015 until we started to see an increase in the last 6-8 months.
Source: Bloomberg, Fidelity International, April 2018.
When we investigate the drivers of this difference we find that the US leverage trend is driven largely by the energy, basic industry and utility sectors. Forecast leverage in US HY energy has gone from ~3x in 2014, up to a peak of 4.5x and now back to around 3.5x. These large fluctuations, predominately driven by oil price volatility, are driving the overall trend. We can see why this exaggerates the US vs European difference if we look at the sector decomposition of the two markets. US HY has close to 10 per cent more Energy (~5 per cent in Europe versus 15 percent in the US) in terms of market weight than Europe (the balancing sector is banking, where Europe has 10 per cent more exposure). In Europe, we have seen deterioration in technology and retail leverage as some idiosyncratic names in these sectors have experienced problems which accounts for the recent increase in net debt to earnings.
Europe’s lack of energy is causing the leverage discrepancy and is responsible for the large divergence in the last three years on the upside and downside. Historically leverage has been at similar levels in the two markets and the energy anomaly of the past few years has now almost normalised. We keep a close eye on what is driving the factors that feed into our models so will be monitoring oil prices and energy leverage as one of the main drivers of Europe vs US HY performance.
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