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Economics Weekly -Will corporate defaults in the UK rise as much as feared? Weekly economic data preview - Focus on BoE and ECB interest rate decisions

Economics Weekly

Will corporate defaults in the UK rise as much as feared?

Financial markets are worried that UK defaults will rise sharply…
In the Q1 2008 Bank of England Credit Conditions Survey (CCS), there was a jump in lenders’ expectations that default rates on loans would rise sharply, see chart a. The chart highlights that there was a greater number of respondents expecting defaults to increase in Q2 than in Q1, which in turn was much worse than in Q4 2007. This is the main reason there was a rise in the cost of lending, to companies and households, to compensate for the higher risk of defaults. It was also one of the reasons why there was a further tightening of credit criteria before a loan is made and a cutting back of the supply of loans being made available. How likely are these fears about defaults to be realised?

...but the data for Q1 2008 were reassuring on this score
The evidence from UK insolvencies in Q1 was rather more reassuring than that suggested by the expectation of lenders in the CCS and also implied by corporate credit spreads, see chart b. This chart shows that the spread of lending to UK companies over safer government bonds implies a sharp rise in corporate failure rates, at least back to the long run average of around 1.4% of companies on the active register against the current failure rate of 0.6%.

Data for UK insolvencies in Q1 show a rise of 2% in the number of companies in liquidation during the quarter and an increase of 4% on the year before - the highest figures since 2006. For individuals there was an increase of 1.7% in insolvencies on the quarter before but a fall of 13.2% on the same period a year ago. On the surface, this would validate the rise in defaults expected by lenders in the CCS and reflected in corporate spreads as shown in charts a and b. But charts c and d show that the changes in Q1 UK insolvency data were relatively modest. What can explain this?

First of all, the increase in the number of companies that failed in Q1 was just 64, nine months into the credit crunch. Moreover, the rate of corporate insolvencies is still very low by historical standards, see chart e. Further, the number of company insolvencies would have to rise by nearly half to reach 2001 levels and then more than double to reach the 1990s peak. For households, the rise in insolvencies was 1.7% but this was just 410 more than in Q4 2007. However, the level of individual insolvencies is at very high levels, see chart c, and could reach new peaks if economic growth were to weaken as significantly as the gloomiest forecasts suggest. This is, of course, the great fear, fed by the fact that this early in the economic cycle there are already signs of rising defaults. The worry is that the figures do eventually mirror the worse concerns reflected in credit markets about the crisis and in expectations that the economic slowdown will be as severe as in the 1990s. But how likely is this to be the case?

However, it is still early days and the more pessimistic views could still be right…
Looking at the relationship between the economic cycle and company defaults, see chart f, highlights that there is indeed a strong link between the economic cycle and insolvencies. And that link is almost coincident, that is, as economic growth slows, company default rates start to rise at almost the same time. So there are legitimate reasons for concern about what will happen to defaults if economic growth were to fall sharply. But economic growth in the UK was 0.44% in Q1, and 2.5% higher than the year before. Employment is holding up, manufacturing output is expanding, and though there are some signs of weakness, there are no signs of impending recession.

…but there would be a very sharp rally in a range of financial markets, if the UK's economic performance turns out to be better
Hence, as chart f shows, even if economic growth slows to the 1.6% consensus view, then corporate defaults will be significantly less than the financial markets are expecting to occur. In turn, this implies that there could a big rally in company shares and in the shares of lenders to them, if this turns out to be the case. Moreover, there would be a narrowing of corporate spreads and a sharp reduction in credit risk attached to lending to the UK corporate sector. But this outcome is still some way off, and it will take convincing signs that the UK economy is not heading for recession for the current negative trends in credit conditions and corporate spreads to unwind. However, by the second half of 2008, all of this will be much clearer.
Trevor Williams, Chief Economist, LTSB Corporate Markets

Weekly economic data preview W/c 5 May 2008

Focus on BoE and ECB interest rate decisions

In the UK, the outcome of the April services PMI, published Tuesday, will play a part in the Bank of England's decision whether to immediately cut interest rates by 0.25% to 4.75% on Thursday, or to delay the move until June, with the possibility that there will be no further cuts at all. Our view is that unless there is a significant fall in the index, to a level below 50, which suggests contraction, the majority of MPC members will vote to hold rates, with David Blanchflower and possibly one other member dissenting. Another 0.25% cut in June or later, is entirely dependent on the depth of economic slowdown from incoming economic data. By contrast, the ECB's stance to hold interest rates at 4%, also on Thursday, is far more clear cut. Whereas there are some signs that the region's economy is slowing, data this week on services growth and retail sales may present a mixed picture, while inflation pressures are evidently rising. US data is likely to provide further indication that the economy is close to, or in recession, providing justification for last week's 0.25% cut to 2% in the Fed funds rate. But there are early indications that financial markets may be over the worst of the credit crunch and evidence that the US economic downturn is finally bottoming out, suggesting that the Fed may also be close to or at the end of its interest rate cutting cycle.

UK data this week will show that despite the deepening slump in the housing market and weak consumer confidence, the service sector is still expanding, albeit at a slower rate. However, should the PMI services index fall below the market median forecast of 51.9, fears of more significant economic slowdown may influence more members of the MPC to vote for an immediate cut, although this is not our central view. In addition, the rising trend of PMI services input and output price indices will highlight the Bank of England's growing challenge on the inflation front, and probable reluctance to lower rates again this month. The April PMI manufacturing survey was stronger than expected, helped by the weaker pound boosting exports to overseas markets. This highlights opportunities for UK high value-added and/ or commodities-based exports this year. Official industrial production figures for March, published Wednesday, are expected to show modest annual expansion.

• The EU-15 April PMI services data should be confirmed above the key level of 50, indicating that the sector is growing, although as with the UK, at a slower pace than in March. EU-15 retail sales may rebound on a monthly basis, but the annual figures are likely to remain in negative territory, which suggests that the consumer sector remains weak as higher energy and foodstuffs prices reduce households' discretionary spending. German official industrial output may have fallen in March, although growth on an annual basis may have remained strong, while new orders may have risen on the month, despite the strong euro. With eurozone inflation running at 3.6% pa, well above the ECB's target rate of 'below, but close to 2%', EU-15 March producer price growth of 0.5% on the month and 5.6% on an annual basis, due Tuesday, will add to the ECB's inflation worries. With this set of figures in mind, a signal from the ECB that interest rates will be cut is very unlikely and, in our opinion, the biggest risk may lie with the possibility of a hike next year, or sooner if the credit crisis suddenly abates.

• Recent indications from minutes and speeches suggest that the US Fed, having lowered interest rates by 3.25% to 2% in a series of rate cuts since last September, now seems likely to pause. There are early indications that the worst of the credit crisis is over and that the downturn in the economy is bottoming out, as highlighted by the better than expected April NFP jobs number and fall in the unemployment rate to 5%. Today's release of the April ISM non-manufacturing index may also surprise on the upside; there is a real possibility that the index was at/ or above 50, indicating expansion. Consumer credit growth and weekly initial claims figures may also show improvement. In terms of the US trade deficit, the soaring cost of commodity and foodstuffs imports may have kept the US trade deficit around the $62bn level in March, annualised at $744bn. Although representing a 10% improvement compared with 2007, it is clearly still reflecting a massive overseas funding requirement.
Nichola James, Senior Economist, LTSB Corporate Markets

Economic Research,
Lloyds TSB Corporate
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London EC2V 7AE
0207 626 - 1500

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