Stagflation dampens markets

Yield curve/duration

Inflation data across the world edged higher over the month. For the EU countries, energy prices were the main culprits pushing inflation higher. And as oil and other energy commodities continue to rise, consumer confidence figures sink lower. Indeed the latest University of Michigan consumer sentiment index for May was at its lowest level for almost 30 years.

The talk from the ECB at its 5 June press conference was extremely hawkish. ECB President Trichet said that rate hikes in July were ‘not excluded’ and that the Bank was in a ‘state of heightened alertness’.  Trichet admitted that several members of the board had even recommended putting up rates immediately.

The reaction to Trichet’s comments was dramatic, with the short end of the curve immediately steepening as interest markets moved to price in a quick 25 basis points rate hike, with another one at the end of the summer. Indeed the inversion of the euro government curves is as marked as it has ever been in its decade long existence. While these rate hikes cannot bring down headline inflation, the ECB will be hoping that by raising rates now, it will be able to choke off potential second round inflationary effects, with wage demands increasing.

Covered bonds

In recent weeks supply has been steadily coming to the covered bonds market and in reasonable size. Also, the maturity has been gradually lengthening too, with a couple of 10-year deals - a mortgage jumbo from EuroHypo, and a public-sector jumbo Pfandbrief from Dexia Kommunalbank.

Digesting the huge supply already pipelined will be one of its greatest hurdles to its ultimate recovery. Certain features of covered bonds trading, which have developed over the course of the crisis, look like they are here to stay for now. There is little sign that the market will end the clear division between Iberian, UK and Irish covered bonds markets, led by Germany. It is becoming clear that investors are also requiring differing premia for different asset cover types. Credit considerations have now assumed a greater priority for covered bonds.

More bad news from the UK as mortgage lender Bradford and Bingley (B&B) announced a profit warning. Each of the rating agencies reacted quickly, by cutting ratings on existing B&B paper and keeping the bank on negative watch.

Investment grade credit

With energy prices continuing to rise, there have been some beneficiaries, most directly the energy stocks which have in turn helped drag stock markets higher. However, the underlying worry for all credit is that economic woes are still severe, that the consumer is under pressure and, with inflation so high throughout the world, central banks are unlikely to be resorting to loosening monetary policy in order to rescue beleaguered corporate and consumer balance sheets.

Investment grade spreads have been narrowing since April, but the trend has weakened as fears over the strength of the global economy have re-surfaced. With talk of recession, or even stagflation, credit markets remain wary. Supply has been drying up, not catastrophically as at the turn of the year, but enough to
suggest that life is tough, borrowers are baulking at the higher
level of yields/borrowing costs and after the surge in supply in recent weeks perhaps investors have rather less cash to put to work anyway.

Depressing though the fundamental outlook may be, investors must be heartened by the sense that the easing of systemic fears is now sufficient for those real macro-economic issues to come
to the fore.

In this scenario, fundamental company research will regain its importance, having been relegated as a side issue during the worst of the capital market’s liquidity problems.

High yield

Unlike its more genteel investment grade sibling, high yield may take rather longer to settle as risk appetites remain dampened and liquidity remains strained. European high yield did have a good second quarter, reversing nearly all the spread widening seen in the first quarter of the year, as government yields rose sharply in response to the inflation threat.

Looking forward, it is difficult to see what could pull spreads much narrower, and with the prospect of rising inflation and slower global growth the pressure will probably be for credit spreads everywhere to widen.

The big question is how much defaults will rise in the worsening economic conditions. There are already signs of increasing
divergence in operating performance among the high-yield issuers, and as business conditions deteriorate further so too will
corporate deviations widen.

The worry must be that the liquidity problems, not yet fully resolved, will resurface at some point. For cash-strapped corporates looking to refinance or reschedule debt, going cap-in-hand to a banking sector unwilling to lend to anyone, let alone a corporate of less than pristine credit quality.

Emerging markets

An important feature of today’s emerging markets is just how much they have changed over the last decade or so. Many emerging market central banks are tough on inflation and respected by international investors. Balance of payments are in the black, and many emerging markets’ commercial and capital markets now operate with little, or no, centralised control. So the times of wildly diverging capital market performances should be a thing of the past.

However, repeating the theme of increasing divergence within asset classes, as global economic conditions deteriorate, there will be increasing differences between performances in the coming months. Those emerging market economies most open to the rest of the world will suffer most as the developed economies, led by the US, slow down or indeed shrink and require far fewer imported goods.

Economies will also enact differing responses to the higher prices. Some emerging market governments, China, India, Argentina to name a few, have put in measures to control prices, which will distort the response of those countries to further rises, or perhaps falls, in the international price of goods and energy.

Credit derivatives

News that UBS, the Swiss investment bank, is to close its US municipal bond underwriting unit, the third largest, as it works to rebuild itself having lost over US$35bn (€22.8bn) in the ongoing credit crunch, comes as another blow to the derivatives market, where any bad news seems to become, like many derivative products, even more highly leveraged.

That news almost coincided with the announcement from Standard and Poor’s, the credit rating agency, that it was cutting the ratings of the world’s two largest bond insurers, MBIA and Ambac. The moves will affect around US$1trn of debt insured by the two. Moody’s has announced that it has placed both companies’ ratings under negative review.

These actions will come as a damaging reminder that the problems in CDOs remain and that there is still much more pain to be endured by the investment banks, rating agencies, bond insurers and investors who are all still involved.

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