US credit underperforms equity ahead of Brexit vote – Goldman Sachs

Research Team at Goldman Sachs, suggests that over the past three days, US credit markets have been weak relative to equity on our constituent matched relative value comparisons.

Key Quotes

“Given the strong performance of credit relative to equity over the prior 4 months, weakness in credit appears to us as “mean-reversion” rather than a divergent view. As a couple of potential tail risk events for the market approach (Brexit vote on 23-June and final TLAC rules from the Fed in the coming months) we look across US credit and equity to identify the largest divergences between US equity and credit in Financials

Where is US credit trading most rich to equity?

(1) US High yield credit has rallied significantly over the past 4 months, diverging from equity as oil prices recovered and global growth risk receded. Based on returns over the past year, the equities in the HYG are lagging the credits by 9%, a 2 standard deviation dislocation.

(2) Bank credits in the US have also outperformed their equities, even as the broader CDX IG index has traded in-line with equity. From a tactical perspective, based on returns over the past year, selling 5Y CDS has outpaced buying the equities by 22%, a 2 standard deviation dislocation.

Fundamentals drove Financials credit to outperform equity

For the past year (and more), we have held the view that ongoing regulatory oversight, leading to increased capital, leverage and liquidity requirements (among other changes) would lead bank credit to outperform equity. Disappointing bank earnings in the past couple quarters have led equity investors to revise their expectations lower, pressuring stocks even as credit spreads tighten (given early earnings weakness is not yet a credit concern).

In our view, the fundamental drivers of financials credit outperformance justify continued outperformance over equity over the next year, even if absolute spreads continue to widen in the near term; however, as we approach these key tail risk events, we see the potential for volatility in this relationship, especially as US bank credit spreads remain tight compared with many of their European counterparts.

How much outperformance is too much?

Over the past 7 years, we have identified many dislocations between credit and equity in our research. We find that even when divergences have strong fundamental justification, there are volatile periods of adjustment as quantitative investors lean against change.

In this context, we see the potential for volatility in the relationship between Financials credit and equity. In our view, Buying 5Y CDS protection on US banks appears an attractive hedge for equity investors that see the potential for a temporary mean-reversion in this relationship.”