Batten down the hatches
The resilience of the European economy brought to the fore in January the question of whether the European Central Bank (ECB) would dare raise rates. In contrast, recent US employment data indicates significant weakness, particularly in the construction and manufacturing sectors. Can there be such a decoupling of these regions, with the US slipping into recession on one side and the euro-zone economy continuing to grow steadily on the other?
In addition to the credit crunch and banking worries, the European economy is also having to battle with a super strong currency. But the ECB is still worried about inflation and may well on hold for now, unlike the US Federal Reserve (Fed) where 50bps cuts are now being priced in.
Last year did see a significant decoupling of government bond markets, especially at the short end. Much of the divergence of policy directions between the ECB and Fed are already priced in. We may be approaching a time when the crossing over of US Treasury and euro-government yields moves into reverse, and we may perhaps see the latter start to outperform.
The Christmas holiday was very welcome for the covered bond (CB) market, coming as it did in the midst such an uncomfortable trading environment. Returning to work, it seems that for now the Jumbo market is not to be split by the introduction of a dual pricing system.
In recommending a tighter bid-offer spread on higher minimum deal sizes, the European Covered Bond Council was hoping that investor sentiment would have improved markedly over the Christmas holidays. Whilst there may be no official split in trading spreads, there remains a clear delineation between on one side, UK, Spanish and Irish and on the other German, French and other country CBs.
Spreads between similarly rated new issues, of different nationality issuers are launching at significantly wider spreads than they were a year ago.
Although the quality of the underlying asset pools has not changed, it is the perception of the systemic risks of the respective individual country’s banking systems which is perhaps having a greater influence on investor appetites than what the rating agencies might be saying.
With a sizeable supply pipeline the market’s discomfort is likely to remain quite acute. Many issuers, having delayed their issuance during those particularly tense months as 2007 drew to a close, are now more than ready to come to the market.
Investment grade credit
his year will most likely be another challenging one for investment grade credit. Tensions in the market and sentiment will have more influence than macro-economic fundamentals on spreads for now. Unlike last year, however, fundamentals are not looking quite so supportive for credit. US housing remains extremely weak with building permits, housing starts and new home sales each at multi-year lows. The huge downward revisions in the financial sector will doubtless presage similar, though not so dramatic, alterations to fourth quarter earnings both in the US, the UK and several countries within the euro-zone.
Oil prices look set to remain very strong for the medium term at least and this will be a negative force for all the oil importing countries. While today’s situation is clearly different, it is worth remembering that thirty years ago the Iranian revolution of 1979 and subsequent rocketing of the oil price led directly to a global economic slowdown.
It was definitely the end of the good times for high yield (HY). In the US, total returns turned in just over 2% in US dollar terms, way down on the double digit returns in each of the past five years. In fact, during the worst periods of 2007’s market turmoils, spreads were blown out from all time lows to nearly five-year highs. In Europe, the primary market has effectively been closed since the summer of 2007.
Although spreads are more generous than they have been for years, very few investors would be advocating any move to overweight, at least not strategically. European HY bond markets have been taking their cue from both equities and US HY. Consequently, talk of recession in the US hit Europe’s HY market badly. Default rates are expected to rise, albeit from historically low levels.
While corporate Europe may indeed be in better shape, in terms of balance sheets, than its US equivalent, wider borrowing spreads and significantly more risk averse investors is a tough combination. Sector selection, together with strong balance sheets would seem to be key considerations this year.
On top of unease over the credit crunch generally, emerging markets (EM) have another growing concern: inflation. Price data have continued to surprise on the upside in many EM countries, especially across Latin America and eastern Europe.
For Venezuela, 2008 sees the launch of a new currency, the bolivar fuerte, which removes three zeroes from the previous currency. Although there was a possibility that the Central Bank would devalue the currency at the same time, in fact the official exchange rate was maintained. Inflation reached 22.7% over 2007 and core inflation almost 30%.
Loose monetary and fiscal policies mean that there is little chance of inflation being beaten and some analysts are now suggesting that Venezuela might introduce a dual exchange rate system in order to deal with increasing pressure on the capital controls. Coupled with volatile politics, investors will need much persuading to park money here.
Asian growth (ex-Japan) is forecast to fall from 9.3% in 2007 to around 8.8% this year. But Asia cannot be immune to the US slowdown and the credit crunch, and despite these macro fundamentals remaining so strong, sentiment will prove the strongest influence.
The big debate for credit derivatives and structured credit in general is whether they will recover and regroup as we sail through 2008, or on the other hand whether they have truly had their day. In fact it still feels too early to tell, although it seems fair to suggest that the reality might lie in between those extremes.
The sub-prime crisis has triggered the most severe slump in US house prices since the 1930s with the credit derivatives market coming under significant pressure. With hindsight, the rating agencies should at the outset have done some more work analysing the outcomes if asset prices did fall that much and rated accordingly, and perhaps the pain suffered would have been less as investors would have felt better prepared for ‘the worst’.
If blame for hammering confidence in the credit derivatives market is to be apportioned however, then surely those who created such a tangled and inter-connected derivatives market much shoulder a large part of it. The complexity of new product was increasing exponentially, and with it a huge degree of interconnectivity and correlations.