Looking ahead to recession
The US economy slid into recession in December 2007, says the National Bureau of Economic Research. As we start 2009 the extreme pain being felt in both the jobs and the housing markets is not easing; figures from the Mortgage Bankers Association suggest that in Q3 2008 one in 10 US homeowners is either behind in their payments or facing foreclosure.
Manufacturing production appeared to be in freefall through Q4 2008, with some Japanese data as negative as that experienced during the oil crisis of 1973/74. It is possible that Q4 manufacturing in the UK may have contracted by as much as 5%.
Both the European Central Bank (ECB) and the Bank of England (BoE) made headline-making interest-rate moves in early December, the ECB making the biggest cut ever made in its 10-year existence and the BoE cutting its base rate to 2%.
Some commentators argue that central banks should be looking to the Japanese experience at the beginning of 2001, when the Bank of Japan (BoJ) began a new monetary policy known as ‘quantitative easing' in its attempts to rid the system of the crushing deflationary pressures and revive the moribund economy. Another key element in the Japanese experience was the BoJ's commitment to eradicate deflation.
By abandoning short end rate targeting and instead purchasing huge amounts of government bonds, asset-backed securities and even equities, the BoJ flooded the financial system with excess liquidity. While the US and UK central banks have both embarked on somewhat similar paths, the ECB has yet to alter its course, and although it has acknowledged that it could buy securities outright, it has not so far done so.
The jumbo covered bond (CB) market is suffering. Buyers are staying on the sidelines, reluctant to put money to work in the market while liquidity - previously one of the jumbo CB market's strongest selling points - remains poor. Spreads have widened significantly, and issuance has dwindled to a trickle from various tap issuance programmes. But huge outflows from mutual funds (German outflows have been breaking records) must surely mean that ongoing demand for products will be markedly lower.
State-guaranteed bank issues are essentially the only products sure to find homes, a reflection of the sad fall from grace of AAA-rated jumbos, previously considered so safe, liquid and reliable. The pricing of other covered bonds, and especially longer-dated ones, is driven by the almost total lack of liquidity - there appears to be no demand at all, at any price for such assets that lack state support. The question is how long this market will need state support in order to restore decent investor confidence.
There are flickerings of light in the darkness that is risk aversion, if not across the spectrum then at least for the very best credits - albeit at some amazingly wide spreads. Supply in the cash markets has been flowing, and some demand has been there to receive it. The relief has been palpable.
There is little doubt that spread premia in investment grade markets are pricing in a huge amount of bad news, but such is the degree of uncertainty still hanging over the world, about just how severe the global downturn could be and how long and hard it will be to clamber out, it remains very hard to identify just who will step up to be the first marginal buyer in this deleveraging world.
Perhaps the best that can be said for now is that as volatility drops, even if painfully slowly, then the perceived risks of potential further widening diminishes, making the shorting of risk an increasingly expensive and ultimately less profitable operation. At some point the bears throw in the towel. While that may not immediately trigger the arrival of a stampede of bulls, it could mark a very significant and welcome pivotal moment.
I n December the iTraxx Crossover index broke through 1,000bps for the first time since its launch four years ago. At this level the break-even default rate reached 47%, implying that as many as half the index constituents may default. This may seem somewhat incredible, but history suggests it may not be so unbelievable. According to historical data from Moody's, default rates for BB/B-rated names have sometimes peaked at up to 53%.
This is the dichotomy for high yield: while there seems to be a viable recovery going on in the LIBOR markets, this is simply not translating into any form of assistance for high yield where spreads hit ever higher highs. Whereas equity markets might be correct in predicting - or hoping - that massive fiscal easing might go some way to reflate collapsing output, credit markets, and especially high yield, needs more. Interest rates across the whole term structure have to come down meaningfully, so that companies up and down the entire credit ladder can have access to liquidity.
While few, if any, observers expected that emerging markets (EMs) could be relatively immune to a financial crisis triggered by event in the US, there have been huge outflows from these regions, as terror of ‘risk' gripped the world.
However, this crisis is very different and the sell-off in EM countries has actually been no more shocking than in other risk assets. However in the twenty-first century there are now many EM countries whose fiscal health is extremely strong and whose political and financial authorities are greatly respected.
However, there will be much more pain to be felt. EMs have plenty of banks, many of which are also in trouble. Of course there are still the ‘basket cases' - perhaps Argentina or Venezuela jump to mind - but there will be other countries, which may try hard but whose problems run much deeper.
In 2009 there will unquestionably be defaults and IMF rescue packages.
For structured credit there is still no respite. Ratings carry no influence whatsoever, with all AAA-rated CLO's, credit card and pretty much all mortgage-backed securities at spreads of 500bps or more. But as commentators debate whether the recession will just be very deep or whether ‘depression' will be the more accurate description, the outlook for credit and structured products remains extremely grim. According to Wall Street analysts, there is a very strong possibility that almost all single-A or below rated US CLO tranches will suffer complete principal loss, and that even some AA-rated tranches could take principal hits.
Aside from the pretty obvious conclusion that the ratings on these products are meaningless, for many investors these awful forecasts spell the end for such structured products as viable assets for their investment portfolios.