Credit spreads in focus

Last week saw core European manufacturing lead indicator Purchasing Manager Indices (PMIs) dip below their pre-LTRO levels for Germany (48.1, against the consensus expectation of  51) and France (47.6, against the consensus of 50.2), and both are now indicating the risk of contraction. While contraction is widely anticipated for many of the peripheral economies, there is cause for concern if core Europe starts to contract for a sustained period. Meanwhile, apart from the challenges of Europe, we are watching events closely in both China and the US from a growth perspective, not to mention the price of oil.

Focusing in on the European issues, as a corollary to weaker than consensus PMIs for the key core economies, we need to keep a beady eye on what the market is pricing as evidenced by credit spreads. It’s no surprise that the ECB’s LTROs provided particular benefit to peripheral bond investors in the calendar year to date not least because the provision of liquidity at least pushed back a crisis that looked imminent at start year. But we ought to question whether such a risk rally is warranted, and indeed sustainable, with peripheral Europe expected to be in deep recession in 2012 and facing sizeable fiscal and structural challenges.

It’s also worth noting that the context for spread movements is extreme volatility which has been the pattern since 2010. To put some numbers to this, the strong risk on/risk off contraction and expansion of peripheral spreads has involved the bonds of Portugal, Ireland, Italy, Greece and Spain exhibiting a beta of 2 against the core Euroland markets – in other words the sovereign debt issues of the peripheral economies have been twice as volatile as the sovereign debt issues of the core economies.

Whilst peripheral economies’ sovereign debt markets have benefited most from the ECB’s provision of liquidity, spreads within the core economies are at 120bps. This take us back to the tight levels observed in November last year before re-pricing into year end. To put this in context, the lowest spread levels for the core economies in 2011 and 2010 were 100bps. In 2011, core spreads traded in a range from 100bp to 185bps, and in 2010 the trading range was 100bp to 147bps.

As for what’s been driving core spreads, it looks to be the same as for credit markets generally: there has been a liquidity-fuelled recovery but fundamentals remain weak at best.

Markets have also been helped by technical factors including negative net supply in both non-financials and senior bank funding markets, as well as strong inflows into credit, offering carry trade opportunities in a low yield environment. New issue premiums have all but disappeared in non-financials and are a rather skimpy 10bps, on average, for senior bank issuance. Despite the lower new issue premiums, order books for new issues are still elevated but have come down from their peaks in January and February. In addition, we are seeing more idiosyncratic behaviour in new issue performance than was the case earlier in the year. Credit surveys by banks suggest a consensus preference to be long credit yet credit markets have had a strong recovery from year end when valuations and breakevens looked much more compelling. With continued risks and less attractive pricing, we may yet turn out to be in a market environment driven more by risk appetite and so called ‘risk on’ and ‘risk off’ than fundamentals.

We may conclude that unless there’s evidence to the contrary that we remain in a range-trading market with potential for bouts of elevated volatility. Core spreads may continue to benefit from perceived ‘safe haven’ status with ongoing challenges for the peripheral economies, and core non-financial credit spreads will likely exhibit much lower volatility than peripherals or financials. But arguably spreads do look tight pending more clarity on growth and the impact of austerity on the core economies of Europe.

As a broader portfolio message, whilst we acknowledge that systemic risk has greatly reduced as a consequence of the ECB’s actions, many challenges still remain, and particularly the scale of the de-leveraging exercise globally. This suggests that ‘risk-on’ may be better expressed through equities than credit debt, and cautious investors may elect to take selective risk off the table, positioning more defensively. Indeed, given the tendency for liquidity to disappear quickly when market uncertainty increases, investors wanting to access cash from their asset base in the near term, may want to do so now.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla