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Credit Market Analysis - Equity market correction: which corporate sectors are more vulnerable to increasedCredit Market Analysis
Equity market correction: which corporate sectors are more vulnerable to increased
Increase in risk aversion triggered by a sharp fall
in Chinese stocks...
The rise in market risk aversion this week, triggered by a sharp fall of nearly 10% in Chinese stock prices in one day, has led to falls in global equity prices. Investor demand for safer government bonds has risen, pushing 10yr yields lower in the US, eurozone and UK by more than 10bps. The VIX equity volatility index, currently at 15.8, had increased to a high of 18.3, well above the 10-12 range in recent months, see chart a on the next page.
... resulting in a weaker yen and a safe-haven bid for government bonds...
In the currency markets, the Japanese yen has been the main beneficiary, as investors reversed carry trades (borrowing in low-yielding currencies such as the yen), which had previously contributed to the decline in credit default swaps (CDS). Consequently, CDS in recent days have risen significantly, as have corporate credit spreads to benchmark government bond yields, particularly in the high-yield or low-grade sector.
...as well as wider emerging-market and credit spreads, and a steeper credit curve
As table 1 shows, high-yield corporate credit spreads versus benchmark sovereign bond yields in the past week have widened 33bps in the US, 29bps in the eurozone and 48bps in the UK, according to Merrill Lynch indices - see chart b. High-grade corporate spreads have also widened, though by only 1-4bps. Emerging-market spreads have risen 25bps, according to the data.
In the CDS markets, the cost of protection has risen, with the main iTraxx Europe 5yr index (series 6) in the past week up about 2bps to 23.1bps, while the crossover index has increased about 43bps to 213.8bps, see chart c. The credit curve has also steepened, as reflected by a widening of the 3/10yr CDS spread to 31.8bps from 30.2bps a week earlier - see chart d and also the technical analysis on page 4.
Which sectors outperform during risk aversion?
To answer this question, we look back to the rise in risk aversion in May-June 2006 and the impact it had on credit default swaps by sector. Going further back, we look at Merrill Lynch indices for corporate spreads during the 2001/2, a turbulent period characterised by the bursting of the TMT bubble, a US recession, the 9/11 terrorist attacks and corporate scandals such as Enron.
During the repricing of risk last May/June, chart e on the next page shows that the cost of protection rose the most for the industrial and financial subordinated CDS sub-indices, while the TMT and energy sectors appeared to be the least affected.
What about 2001/2? Corporate credit spreads rose strongly in the high-yield sector, with corporate yields 10% (or 1,000bps) above treasury yields. They are currently about 2.8% above treasury yields. Chart f shows that spreads for high-yield total and for the telecom, energy and utility sectors.
Chart g shows corporate spreads for the high grade sector. High-grade spreads versus treasuries peaked at about 2.5% and have fallen to less than 1%. Spreads were particularly wide for telecom corporate bonds, peaking at around 4.5% above treasury yields. More recently, the consumer cyclical sector has underperformed, with spreads widening to 3% during 2005, related to the GM downgrade. Not surprisingly, the consumer non-cyclical sector was less affected by the general wideningof spreads and therefore outperformed during 2001/ 02.
What is likely to happen in the future?
We believe that the recent events highlight the credit market's high sensitivity to the repricing of risk. This is because the tight corporate spreads and low cost of protection implied in credit default swaps have been driven by ample liquidity and strong investor demand, over and above that may be justified by our view of solid macroeconomic fundamentals.
In the coming year, we may get more episodes like the one we saw last week and last May-June. From a historical point of view (compared with 2001/2), these corrections have been minor, but they serve as reminders that macroeconomic and event risks should be more adequately accounted for in asset prices.
Therefore, we do not expect the credit markets to slump and spreads to widen in the way they did during 2001/2, unless we experience a similar confluence of events, namely an equity crash, US recession, terrorist attacks and investment scandals.
Our central view, therefore, is that macroeconomic fundamentals will remain positive, maintaining healthy growth in corporate profits, while global interest rates are likely to remain relatively low, thanks to low inflation worldwide. Investors may become more cautious and this will reduce the supply of liquidity placed in riskier assets such as high-yield bonds. Therefore, we expect corporate default rates and credit spreads to widen this year, but at a moderate pace on average (see table 2 on the first page), but it is likely to be a bumpier ride than in recent times.
As for the sectoral outlook, our forecasts for combined US, Europe and Japan output growth show that sectors related to capital goods and electrical engineering (including technology and electronics) may outperform this year. Financial and business services are also expected to grow above average. Underperforming sectors include basic industries, construction and some consumer categories â€“ see table 3 below.
Hann-Ju Ho, Senior Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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