Recent Markets Rebound: Sustainable or Temporary?
Co-written with other RGE Lead Analysts.
Sure, markets enjoyed a refreshing rebound last week following the Fed’s rate cuts and hopes of a monolines rescue but risky asset markets remain down for the year and the near-term outlook is uncertain and volatile. The financial crisis is not over yet and the economic recession in the U.S. may end up more severe than expected given the shocking news on Tuesday of a sharp drop of the non-manufacturing ISM index and ensuing sharp correction in U.S. equity markets. Emerging market markets have re-coupled with developed markets, credit markets continue to correct and US stocks look likely to head lower on a profit growth and valuations basis. Take a look at: “Are U.S. Stocks Overvalued or Undervalued?”
Traditional safe havens, such as Treasuries have struck multi-year low yields or, in the case of gold all-time nominal high prices. They may be vulnerable to corrections: gold if a severe recession leads to lower inflationary pressures; government bonds if the recession is mild and followed by a rapid recovery. Even non-traditional safe havens, such as emerging market debt, have succumbed to the financial crisis-induced sell-off as the decoupling theory loses currency among emerging market investors. Read: “EM Sovereign Bonds: Wracked by Recoupling“
Is there anywhere to run and hide from a U.S. recession? Check out: “Safe Havens from U.S. Recession: Where to Run and Hide”
While oil, energy and commodity prices are still high they are starting to fall from their peaks – as for oil and the Baltic Dry Index for freight –following the expectations of a US recession and a global economic slowdown. Further sharp falls in commodity prices are likely if the U.S. recession and global slowdown are greater than currently priced by the markets. And in a scenario of worsening recession and easing of inflationary pressures yields on government bonds may head further south rather than correct upward. Check out: “Commodities Volatile on U.S. Recession Bets” and “Will US 10-Year Treasury Yields Rebound or Fall Further?”
Though equities aren’t safe havens, there is relative value to be found within the asset class. For example, some analysts believe European equities will keep besting its U.S. counterparts. But U.S. and global equities will be driven by macro developments. The recent equities rally – after the severe slump in the first half of January – was predicated on the hope that the Fed easing and a possible rescue of the monolines will prevent a severe recession. But the non-manufacturing ISM is a clear signal that the worst may be ahead for the U.S. economy and for financial markets. Thus, an equities correction that turns into an outright bear market cannot be ruled out.
The U.S. economic weakness hasn’t benefited the euro, which is looking tired after its run against the dollar since mid-2007. Last week, the euro failed to move ahead of its all-time high versus the U.S. dollar despite fresh signs of weakness in the U.S. economy and the reversal of the yield differential in the euro’s favor after the Fed’s 125bps cuts. Why the reprieve? Is it winding up for the punch that will break its lifetime record? More likely expectations that aggressive Fed easing will lead to a faster U.S. growth recovery after the recession and expectations that the ECB stalling will cause a more pronounced Eurozone growth slowdown are – paradoxically – bullish for the dollar and bearish for the euro. But with the forward looking data on the service sector being surprisingly bad for both Europe and the U.S., the dollar-euro rate ahead will depend on volatile expectations of relative growth differentials and of relative interest rate differentials. Check out: “Has the EUR/USD Exhausted Its Run?” And for the outlook on the other side of the currency cross, take a look at “Does the U.S. Need a New Dollar Policy or Will USD Rebound in 2008?”for direction, and “Will USD Decline Smoothly or Crash into a Dollar Crisis?”for speed of future movements.
The large chunks cut out of the Fed’s official interest rates last month yielded inquiries into whether the U.S. will arrest the real estate price deflation or fall into a liquidity trap. A retrospective on Japan’s experience in the 1990s, draws parallels and policy prescriptions for central banks battling a financial crisis at low short-term interest rates. Read: “Japanese Lessons for the Fed: How to Avoid Deflation, Liquidity Traps”
Finally the credit crunch: encouraging signs of normalization in the money and interbank markets led the ECB to halt its temporary liquidity auctions on February 4 after injecting more than $550bn since December; whereas the Fed said it will provide another $60bn through TAF auctions this month. USD LIBOR fixings edged a little higher in response for the first time in weeks. What is the further outlook? A decomposition of swap spreads shows that whereas LIBOR was mainly driven by liquidity concerns in 2007, credit premia reached new highs in January and are now the main driving force in keeping LIBOR spreads elevated in line with the signals from corporate credit markets, especially in the financial sector. Read: Credit Squeeze Won’t Go Away: What Are Central Banks’ Alternative Tools?
And the signals from corporate credit markets are not all good. Whereas investment-grade corporate bond issuance picked up again in Q4, lower interest rates and higher risk premia have eroded returns on once vibrant leveraged loans and high-yield bond investments as to bring the market to a virtual standstill. Among the investors caught wrong-footed are not only investment banks with $250bn of ‘hung loans’ on their books, but mostly hedge funds and non-financial corporations who provided about 75% of loans to junk-rated companies as of H1 2007. Moody’s sharply higher default estimates for junk-rated debt of 10% by the end of 2008 in case of a U.S. recession reflects the ongoing value erosion accordingly.
The leveraged loan index spreads LCDX and LevX for the U.S. and Europe respectively, are at crisis highs (450bp 5-year spread in U.S.; crisis-low of 94 cents on the dollar for LevX in Europe.) The implied credit risk of high-yield bonds as measured by the CDX.HY in the U.S. and the iTraxx Crossover in Europe shows a similar increase in credit spreads from 207bp over LIBOR in September to 504 on February 5 (numbers for Europe). Junk bond yields are now close to 700bps above Treasuries from a bottom of 260bps in mid June. But also investment-grade bonds are not immune: In the U.S., the CDX.IG spread rose to 110bp from 50bp in September with similar moves in the European iTraxx.
Perhaps the best example of the perfect storm sweeping the credit markets may be the monol
ine bond insurers. They have become the ultimate link between the ailing U.S. mortgage sector, the corporate sector, and the municipal bond market in the new era of financial innovation and contagion – indeed, of the 8 financial institutions negotiating a potential bail-out, 5 are reported to be European. A failure of the attempt to rescue the monolines from a rating downgrade will add another serious leg to markets’ concerns about systemic financial risk.
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