Corporate Europe is worried about the business outlook: both sentiment indicators and real economic news have been deteriorating over the summer. But with headline inflation so far above the European Central Bank’s (ECB) own target rate - in fact it hit double that level in July - there remains little chance that the Bank will be cutting rates soon. But there is considerable relief that core inflation has remained well contained so far.
For the Bank of England, the dilemma is more acute: can they afford to raise rates in the face of such compellingly bad news from the UK economy and housing market, but equally can they afford not to when inflation looks set to rise to 5% ?
While the global economy is clearly slowing, a few observers believe that some bad news is being rather exaggerated. They suggest that most of the really negative opinions are emanating from those economists employed within the anguished financial sector itself, and that their apocalyptic outlook for the real economy is possibly too gloomy for the outside world.
But the consensus, by far the majority view, is that the problems in the banking system will continue to be transmitted through to business and consumers in the form of greatly restricted lending practices which will weigh heavily alongside the pressure from rising costs.
The Bush administration released a set of best practices for the launch of residential covered bonds. US Treasury Secretary Hank Paulson announced that this initiative would serve to increase the availability of affordable mortgage financing, essential to “turning the corner on the current housing correction”.
Also endorsed by the US Federal Reserve, which stated that it would accept residential covered bonds as collateral, four banks including Citigroup and JP Morgan, put out a joint statement signalling their commitment to becoming issuers within the nascent covered bond market and helping to ensure its success.
The building of this market will not be easy at this time, given the huge damage to the US mortgage market and investors will be wary, no matter how far removed these residential covered bonds will be from any of the troubled sub-prime related securitised products.
Eventually, it seems likely that US covered bonds will become a viable asset class, important to investors and banks alike, and in time help to strengthen the US real-estate market.
Investment grade credit
European earnings are currently significantly above their long-term trend, and could start to look very precarious if growth expectations continue to be revised lower. The outlook is deteriorating as inflation forecasts are revised upwards, and sentiment surveys indicate both businesses and consumers believe that conditions will probably worsen in the coming months.
Investment grade spreads have already discounted much of the bad economic news and a quite severe slowdown in the euro-zone. Second quarter results have mainly been reasonable. Corporate balance sheets are in good shape; leverage has been falling on a gross and net basis since 2003, despite the ready availability and cheapness of credit in recent years.
Although the banks’ tighter lending standards are bound to send more corporates to issue bonds, pushing up supply which may prove hard to digest, credit spreads appear to have already discounted more bad news than other asset classes, and could be better positioned to weather the ongoing storm. If this turns into a more traditional downturn, it could be wise to be pay most attention to the cyclicality of underlying businesses as well as closely monitoring individual capital needs.
Continuing with the theme of capital needs, it is not hard to see how the high yield market might find it very difficult to raise capital for some time to come. There is still no life in the European high yield primary market, where issuance has virtually dried up since mid-2007, in contrast to the investment grade market where bond issuance is running in line with that seen in previous years.
If the equity markets are right to be now pricing in some sort of a ‘traditional’ cyclical downturn, with utilities and tobacco outperforming autos and other cyclicals, then the argument ought to continue to reduce portfolio beta and carry on moving up the ratings ladder.
Perhaps this is already the consensus view. Investment grade credit has certainly been outperforming high yield over the past few months, and within high yield, the lowest rated and distressed paper has continued to underperform the rest.
Although being part of the consensus can become uncomfortable, there remain too many dark ‘what if’ scenarios for high yield, not least the very real possibility that default rates could start to climb sharply as lending is further restricted by the banks, and refinancing risks rise.
The slowdown is beginning to affect more of the emerging market (EM) universe, with many EMs showing moderating economic growth coupled with high inflation. Chinese economic growth overall has slowed only marginally, and Chinese export growth has fallen dramatically from its 20% levels of a year ago to around 6%, reflecting the global slowdown.
The huge rise in the oil price has caused the developed world great anxiety, while global EM inflation has been hugely influenced by food price inflation, which may have already peaked. Whether or not the oil price has peaked, to date EM economies have generally managed to contain possible second round effects of higher food and fuel costs. Investor focus will now be on which EM economies will benefit from falling commodity prices, and those commodity-rich countries which perhaps ought to have used their windfalls rather better.
Argentina is one such country whose policies have been not strong enough and domestic troubles seem to be rising, with speculation that Standard & Poor’s might downgrade its debt. Argentina, currently rated B+ by the agency, has been on ‘negative outlook’ for several months.
Structured credit products are trading in a highly correlated way, suggesting that they continue to be driven by systemic factors, such as the direction of the US economy, liquidity issues, and news about the banking system in general.
Merrill Lynch raised some eyebrows with its announcement to sell $30bn (€20bn) of super senior ABS-CDO paper to an affiliate of Lone Star Funds. This is not the first bank to clean up its balance sheet in this way; UBS sold a similar amount back in the spring.
Estimates vary but it seems likely that the deal reduces Merrill Lynch’s gross CDO exposure by 60% taking it down to $8.8bn (net exposure $1.6bn). There is much clearing out even now to be done, and Merrill Lynch still has large amounts of Alt-A and sub-prime mortgages.
What was perhaps most disheartening for the market, was not the reality that other investment banks were going to undergo similar deals, but the depressingly low agreed clearing price - only 22 cents on the dollar - which depressed an already