Looks like a soft landing for the US
The US economy may be heading for a soft landing after all, which is pretty much in line with the expectations of the policy makers themselves, namely the Federal Open Market Committee led by Chairman Bernanke. So far bond markets, led by US Treasuries, have been reasonably sanguine about the prospects for interest rates and do not seem to have made the assumption that higher economic activity must translate into higher interest rates.
There seems to have been fewer surprises on this side of the Atlantic, and the outlook for interest rates in the Euro-zone is for the European Central Bank (ECB) to continue tightening its monetary policy. Nonetheless, there has been bond-positive news: price stability appears to be generally intact, with the recent VAT hikes in Germany seemingly not translating directly into higher headline inflation in January. And recent data appears to be pointing to the fact that economic activity
in the Euro-zone may be peaking, or might already have done so.
However, the bad news for the bonds side was undoubtedly the large leap in the money supply growth - to its highest (pan-European equivalent) level since the early 1990s - a development which will definitely put the ECB on alert. A rate hike in March is already priced into the European bond markets, and the ECB’s post meeting statement in February left little doubt - the coded reference to ‘strong vigilance’ - that a rate move in March was indeed on the cards.
Spreads have continued to hold in well, with any changes being more or less directly linked to supply, or lack thereof. Although there was significantly lower covered bond issuance in January 2007 than the previous year, this is not being seen as some sinister development for the covered bond market. Historically, during the first quarter of the year, issuance of Spanish Cedulas peaks towards the end of February and March. In 2006, however, the significant issuance took place in January, hence the apparent year-on-year decline in issuance.
More pertinent than comparing year on year supply, is watching the continuing widening of the geographical spread of Jumbo issuers coming to the market compared with last year. There were five countries represented in January: Germany, France, Spain, Austria and relative newcomer Sweden, which accounted for just over one fifth of the issuance.
New issues are still being keenly priced, indeed often coming at the lower end of spread expectations. Nevertheless demand also looks set to remain keen.
Investment grade credit
Although investors do appear to be manoeuvring up the credit ladder (see High yield, below) the likelihood of further significant narrowing in investment grade (IG) credit spreads is rather hard to swallow given how skinny the premia are already. However, with no real macro-economic signals that government bond yields anywhere in the developed world are about to soar, the world’s ‘search for yield’ will continue. In this climate, there are plenty of analysts who believe that spreads will indeed grind lower, despite no marked improvement in fundamental conditions.
The more bearish outlook points to a falling oil price as a potential harbinger of gloom. This theory points to the fact that the big
suppliers of capital in 2006 were the oil rich countries like Russia and Saudi Arabia. Should the oil price continue to decline or, in
the worst case, collapse if global growth was halted, then there could be a sharp drying up in global liquidity which would have serious implications for risk premia generally and credit spreads in particular.
That gloomy scenario is, however, for most investors a quite remote probability for now. More dangerous is the growing risk of exposure to LBO and other corporate activities.
It seems to have just got better for high yield - a more optimistic economic scenario without the concomitant fear of higher interest rates, which also brings with it the prospect of default rates levelling out at historic lows rather than creeping higher. Many analysts are suggesting that 2007 could be yet another year for high yield to outperform investment grade, although absolute returns may be lower than in 2006.
Rosy though this outlook is, JP Morgan’s bi-monthly European High Yield Investor Survey for January does have some interesting cautionary notes in it. Overall investor bullishness for credit is down from its all time highs seen in November. In addition, investors have lowered their appetite for those most risky assets (ie, the CCC-rated credits), suggesting that they feel that the rally throughout December and January has perhaps run its course.
Although in the past falling commodity prices would usually herald poor stock and bond performances for all emerging markets (EMs), whether or not they were net commodity consumers or producers, today this effect appears far less in evidence. Today’s EM economies are generally stronger, and so negative influences from falling commodity prices are offset by effective policy management and healthy public finances.
That said, as commodity prices continue to decline, there could be marked divergences between the performances of the commodity-consuming economies of Asia and central Europe which stand to benefit from declining commodity prices, and commodity-rich countries in the Middle East, Latin America and parts of Africa.
There could be significant variations between the good and the bad within each sector. Oil exporter Venezuela has been raising public expenditure as revenues from higher oil prices have also risen. It now seems unlikely policy makers will reverse those spending decisions even as revenues fall and there are clear risks to Venezuela’s fiscal health. In Chile, on the other hand, the authorities have been careful to use lower copper prices in their budget assumptions and have not set extravagant spending plans and, as copper prices continue to weaken, worries about the budget should be less critical.
As in the other fixed income domains, while risk premia remain so narrow, investors increasingly must rely on ever more analysis and more careful selectivity within each sector.
The European Securitsation Forum (ESF) has recently published its annual issuance survey for 2007*. ESF membership includes a wide range of participants involved in European securitisation and they are drawn from securities firms, issuers, investors and asset managers, rating agencies, law firms and stock exchanges, and this annual report surveys and summarises views of that membership.
The report, which covers the range of asset- and mortgage-backed securities, as well as collateralised debt obligations (CDOs) is upbeat, perhaps unsurprisingly, in its findings. Participants are generally expecting that 2007 will be another very strong year of issuance growth and that once again CDOs, and particularly CLOs (collateralised loan obligations), could be the fastest growing sectors again.
Participants are also expecting secondary market liquidity to increase, and base this positive outlook on the improvements to documentation standardisation and increasing transparency. As to the risks to this rosy scenario, these were identified as being related to the strength of European economic growth and the associated worry that the central banks in Europe would have to raise rates more than the consensus forecasts and yield curves have priced in.
*ESF Securitisation Market Outlook for 2007, 7 February 2007.