Complacency a key risk to primary in 2020

After a surprising 2019, what does the year ahead hold in store for euro credit markets, notably bank debt? Vincent Hoarau, head of FI syndicate at Crédit Agricole CIB, suggests that geopolitical developments hold risks for a complacent market, even if technicals will be supportive. And while lower-for-longer is the mantra, issuers should not take demand at negative yields for granted when approaching the primary market.

Bank+Insurance Hybrid Capital: 2019 did not unfold as might have been expected at the beginning of the year. What are the key takeaways from the past 12 months?

Vincent Hoarau, Crédit Agricole CIB: 2019 has been a year of surprises. A year ago, in December 2018, markets were discounting three rate hikes in the US and one rate hike in Europe over the next 12 months. Precisely the opposite materialised, after an unprecedented reversal of monetary policy in the US in early 2019 fully restored confidence that stimulus was coming. Central bankers did away with quantitative tightening, in a prelude to the revival of asset purchases in capital markets.

On 12 September, outgoing ECB president Mario Draghi duly confirmed the introduction of a tiered deposit rate, with its modality suggesting that interest rates could technically move lower than the current minus 0.50%. Markets reacted positively to the prospect of lower rates for a longer period of time, while in the US the balance sheet of the Fed was again growing. Draghi also managed expectations extremely well with the announcement of Quantitative Easing #2 and surprised with less than was anticipated. The market was expecting greater QE (some €40bn-€50bn), but there are simply not enough bonds to buy. What the ECB delivered with the announcement of “only” €20bn was remarkable. Markets appreciated the fact that one of the main objectives was more or less achieved: lowering the cost of spending for (southern) European governments and flattening the long end of their yield curves.

Globally, the overall compression of government bond yields and credit spreads observed throughout 2019 was also supported by the absence of new bad news and the fact that the two major political headaches that dominated H2 2018 and H1 2019, i.e. the US-China trade war and Brexit, had less impact in H2 2019.

In December 2018 we wrote that “the ECB could review its interest rate rise commitment … and this could give succour to the market”. We were certainly right, but we never thought 10 year swap rates could trade as low as minus 30bp and the 10 year Bund as low as minus 0.70%.

What are the key risks to current levels?

Hoarau, CACIB: The US economy is buoyant, with good momentum. So the risk of disappointment is high. The next earnings season will again be decisive for rates and the market’s medium term direction. In this context, overpriced growth stocks are a risk for the market, and we don’t see how an equity market correction would not impact the credit market. At the moment, too many people care too much about stories and narratives and neglect cashflow and profit generation. What does the WeWork debacle mean for peers and global markets? Some situations remind us suspiciously of the 2010-2013 period.

But more importantly, near term, we scrutinise the risks involved in the macro/geopolitical side of the equation, and the uncertainty over trade policy. This can damage global growth durably. After a dramatic escalation over the summer, talks between Beijing and Washington resumed and fuelled strong momentum in Q4. On that front, a “phase one” trade deal by January will reduce investor fears of a global downturn and support a strong start to the year. A negative outcome would be critical for markets.

Staying in the US, in terms of risk factors, the Fed could also prove to be more reluctant to cut rates during an election year even if the macro backdrop deteriorates — another key element in terms of potential market drivers. Elsewhere, the risk of a deterioration in the trade relationship between the US and Europe in 2020 is also on the table, and this is certainly where the next surprise could come from. Finally, Brexit could also have a stronger impact than expected, while Italian politic risks, currently dormant, could resurface.

How is the market poised for the January reopening? How should issuers go about approaching the new year primary market?

Hoarau, CACIB: The markets have priced in only good news. The post-summer credit rally was mainly driven by the prolongation of loose monetary policy across the board and strong fundamentals in the US. Investors have subsequently demonstrated a fairly high level of complacency, sending credit spreads to historical lows and equities to new highs in a very liquid market. President Trump’s most recent pronouncements towards a possible longer and wider than expected trade war could make investors less amenable in January 2020. This could fuel the return of volatility on the equity and rate fronts, even if economic data points remain strong in the US

Pressure on senior non-preferred/HoldCo new issue premiums and spreads could materialise in January on the back of the resurgence of primary market supply. Why should issuers wait when spreads are at historical lows and the senior preferred-SNP subordination premium is as low as 15bp-20bp in core markets? In higher beta, the playground should remain supportive. The AT1 market is structurally undersupplied — particularly in euro-denominated format — so the lower-for-longer rates narrative should support valuations further, while net supply will remain limited.

At the other end of the credit spectrum, the covered bond arena should also benefit from the new situation and remain fairly immune from what may come to pass. With €2bn-plus a month in terms of net purchases and almost €4bn of redemptions to be reinvested by the Eurosystem in January alone, the sector will remain well bid. We also bet on the return in force of opportunistic covered bond buyers, with plenty of liquidity to invest in primary in order to buy bonds they can then recycle with the central banks in the secondary market. The unlimited backstop bid from the Eurosystem is there to stay. Covered bond spreads will therefore remain firm, with supply likely to be well skewed towards long and very long maturities. At the shorter end, decisions over tenor are likely to be driven by the evolution of outright yields. Yes, negative yields work, but the quality of the order book can deteriorate rapidly. We therefore expect issuers to be mindful of the decreasing granularity of order books when the yield on offer turns too negative, and to choose tenor and timing accordingly.

What do you expect in terms of sub debt/bank capital supply in 2020?

Hoarau, CACIB: AT1s outperformed every other asset class in 2019, and for the community of issuers the direct result of this has been the possibility of refinancing existing debt at lower coupon and/or reset spreads. We expect the reset/coupon complex to continue to be favourable for issuers and encourage the refinancing of the existing stock at the first call date. In terms of net supply, it will be limited. Banks have filled their buckets and the forthcoming supply is likely to be to refinance redemptions when bonds are called. The demand/supply dynamic should also support Tier 2 debt, in spite of the expected increase in supply coming from Asia-Pacific. Net supply will remain limited, with a decent amount of redemptions and calls throughout 2020. Gross issuance in euro Tier 2 reached €30bn in 2019. It should not exceed €20bn in 2020, while call amounts are in excess of €10bn.

Funding needs in senior non-preferred format will continue to move within a low to mid-single digit range for individual issuers, and both SNP/HoldCo should reach €160bn across EUR/USD-denominated formats in 2020 versus €180bn in 2019.

What good news could be on the horizon?

Hoarau, CACIB: While the ECB lacks ammunition, Christine Lagarde will likely focus on structural reforms during her mandate and increase pressure on European governments to work on budget policies. So far, the ECB has managed pretty well to reduce the volatility of funding costs for private as well as public sector issuers. The greatest challenge for her will be to connect monetary policy to fiscal policy, i.e. to orchestrate the shift from unconventional monetary policy measures to structural reform and fiscal action. The good news would be to finally see progress on that front after Draghi paved the way during his eight year mandate and bought time for markets. A good scenario would be indeed to see governments following up with a programme of spending. Indeed, over 10 years, Germany is paid 30bp to borrow, while France can spend for free.