SocGen's 'Most Worrying Chart' Shows Markets Still Shrugging Off Political Risk

Credit spreads should be twice as wide.
Photographer: Andrew Harrer/Bloomberg

Political upheaval and the economic policy uncertainty that's accompanied it have left little impression on the corporate bond market in 2016. And that's got researchers at Societe Generale SA concerned.

Even as a wave of surprising election results and a rising populist tide ushered in regime changes in major economies, credit spreads globally are near their tightest levels of the year. Meanwhile, one measure of economic policy uncertainty — propelled upwards by the recent Italian referendum, incoming Trump administration, and a color-coded Brexit — has hit an all-time high.

That massive divergence is depicted in what SocGen Head of Emerging Market and Credit Research Guy Stear calls "the most worrying chart we know."

Source: Societe Generale

Spreads should be twice as wide given the current level of economic policy uncertainty, the strategist reckons.

Global credit spreads were formulated using a weighted average of iBoxx U.S., euro, and U.K. corporate bond indexes relative to their respective benchmarks, while using an index developed by the researchers Scott Baker, Nicholas Bloom, and Stephen Davis to gauge economic policy uncertainty.

"This ought to worry the bulls," Stear writes, who notes that credit markets are underestimating political risk compared to 2008 and 2011, two other occasions when the Baker, Bloom, and Davis index went parabolic. The measure is higher now.

In a separate report, SocGen highlighted the trough in oil prices and the European Central Bank's corporate sector bond purchase program as key to the rally in credit this year.

"In 2008 and 2011, the correlation between economic policy uncertainty and credit spreads was very close," the strategist writes. "As uncertainty rose, so did spreads – but something different is happening now. The Economic Policy Uncertainty index is up at all-time highs, but spreads are at the median levels of the period going back to 2008."

Economic policy uncertainty might not ease in the near term, with elections next year in France, the Netherlands, and Germany having the potential to further testify to the populism that's arisen as a major countervailing force to globalization across advanced economies.

In his year-ahead outlook (titled "The big hangover, part II"), Stear recommends that investors underweight credit in 2017 and wait for a buying opportunity to emerge around the middle of the year.