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Credit Market Analysis: Putting things into contextCredit Market Analysis
Putting the recent credit events in context
Putting things into context
The ratings downgrade of securities backed by subprime mortgages and the near collapse of two Bear Stearns hedge funds, which had invested in the subprime sector, has had a big impact on the financial markets recently, leading to wider credit spreads, though only limited falls in equity prices, as chart a shows. Concerns over the impact of the housing sector on the US economy have therefore resurfaced, leading to a weaker dollar and lower sovereign bond yields.
This comment tries to put recent movements into context and to explain the likely outlook for credit and the wider financial markets. The credit boom of recent years has been a result of a surge in global liquidity levels and low asset price volatility. In particular, global inflation levels have remained low, helped by the increased participation of developing countries, such as China, in the global economy. This has enabled monetary authorities to keep interest rates low. Further, low asset price volatility has reduced risk premiums and encouraged investors to take more risk.
There are signs that the period of easy money is gradually coming to an end, with global deflationary pressures of recent years now subsiding, hence leading to the recent uptrend in global interest rates. Further, the unusually low asset price volatility of recent years is unlikely to persist and this will lead to higher risk premiums and more caution among investors in the next few years.
What is the outlook for credit and the wider financial
The problems in the subprime mortgage market relate to loans made in the past and we believe that they will be largely contained and that the impact on the wider economy will be limited. US consumer spending growth is forecast to ease next year, partly related to high oil prices and ongoing concerns about the housing market, but will remain supported by robust jobs growth. Overall, we expect US growth to rebound in the remainder of this year and next year, as chart b shows.
Banks have already started to tighten credit standards, while investor caution has risen. This suggests that the orderly correction in credit is likely to continue and lead to a gradual widening of credit spreads. Yet, credit spreads remain low by historical standards, even after the recent correction. This suggests that, despite the adjustment from easy money, liquidity will remain sufficiently ample to cushion problems that are occurring in the subprime mortgage market and potential problems in the wider credit market. Therefore, we do not expect a credit crunch. Further, the pool of global savings in Asia and oil-exporting countries will be increasingly used for investment rather than US consumption. This will help underpin robust global economic growth, maintaining growth in equities beyond current short-term volatilities.
Our econometric model suggests spreads to widen 30% in
the next 12 months
Our econometric model of credit spreads is based on equity returns, implied equity volatility, treasury yields and the slope of the yield curve. Despite a projected 5% rise in equities and higher treasury yields in the next 12 months, higher equity volatility, a flatter yield curve and an already low level of credit spreads suggests that US high-yield corporate spreads over treasuries (Merrill Lynch index) will increase by 30% from the end of June to 384bps in a yearâ€™s time, see chart c. However, this would still be below the 5-year average of 463bps. Applied to credit default swaps, this implies the Itraxx 5yr crossover index (series 7) will rise to around 300bps in a year's time from 230bps at the end of June, though the recent rise already to above 280bps suggests either a likely pullback in the short term or an underestimation by the model.
Overall, fundamentals remain important in the global asset valuation story. We expect global economic growth to remain robust, which will maintain growth in corporate profits and provide support for equities. Nevertheless, the risks for asset prices have risen and the unusually low asset price volatility of recent years is unlikely to persist. Banks have already started to tighten credit standards and investor caution has risen, but this implies a gradual adjustment from easy money, rather than a credit crunch.
Our econometric model suggests that high-yield credit spreads will continue to widen, but at a gradual pace. This would still leaving spreads below the 5-year average, implying still high liquidity levels and scope for spreads to widen further. We expect global growth to be increasingly underpinned by rising investment, rather than US consumption, and there will be opportunities in sectors more exposed to rising global investment trends and less dependent on the US consumer.
Hann-Ju Ho, Senior Economist
10 Gresham Street,
London EC2V 7AE
020 7050 6045
* All data and charts are sourced to Lloyds TSB Corporate Markets Economic Research, Merrill Lynch and Bloomberg.
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