Wider spreads and weaker eq­ui­ties

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Over the past five weeks, the spread be­tween US high yield debt and US Trea­suries has widened by al­most a full per­cent­age point. Ad­mit­tedly, this move could be dis­missed as an over­due cor­rec­tion af­ter spreads for high yield debt nar­rowed to un­sus­tain­ably tight lev­els. Un­for­tu­nately, it seems that eq­ui­ties mar­kets are no longer in such a for­giv­ing mood. In the past week, the widen­ing of high yield spreads has weighed heav­ily enough on eq­uity mar­kets to push the Dow Jones, Euros­toxx, Dax, and CAC40 all into neg­a­tive ter­ri­tory for the year. More sur­pris­ingly, this 1ppt jump in US spreads has oc­curred against a back­drop of a) solid eco­nomic growth in the US (as shown by the re­cent GDP num­bers), b) very de­cent cor­po­rate prof­its, c) a com­plete ab­sence of any sig­nif­i­cant US bank­rupt­cies and d) no mean­ing­ful change of tone from the Fed­eral Re­serve on its zero in­ter­est rate pol­icy.

So what ex­plains the pull­back? There are sev­eral pos­si­ble cul­prits: - The Fed’s ta­per­ing? The most ob­vi­ous ex­pla­na­tion for the mar­kets’ re­cent be­hav­iour is that the Fed is in­ject­ing smaller and smaller amounts of liq­uid­ity into the sys­tem and that within two months it will have fin­ished its liq­uid­ity in­jec­tions al­to­gether. In the weeks that fol­lowed the end of QE1 and QE2, mar­kets suf­fered se­vere wob­bles, so per­haps we should ex­pect more of the same this time around. At the very least, per­haps we should ex­pect mar­kets that are priced for per­fec­tion-as junk bonds have been-to move back to­wards fair value and for the Fed to re­main largely in­ac­tive as this hap­pens. - Bad news on banks? Bank shares in Europe and the US have un­der­per­formed markedly in re­cent months. Con­tribut­ing to this un­der­per­for­mance are in­creased reg­u­la­tory pres­sures and pun­ish­ing fines, as well as the need for banks to con­tinue writ­ing off dodgy in­vest­ments from the past (es­pe­cially in Europe). Could this be weigh­ing on the junk bond mar­kets? If banks have less cap­i­tal to back loans, or less in­cli­na­tion to take risk, then high yield debt be­comes the one source of fund­ing for cash-starved cor­po­ra­tions. - Bad news from Europe? The post-2008 cri­sis spikes in spreads (in the spring and summer of 2010, 2011 and 2012) were mostly linked to the un­fold­ing of the Euro­pean cri­sis in which weak banks dragged down sov­er­eigns in a re­lent­lessly vi­cious cy­cle. How­ever, when Mario Draghi re­placed Jean-Claude Trichet at the helm of the Euro­pean Cen­tral Bank and promised to do ‘what­ever it takes’ to keep the euro-show on the road, the mar­ket started to price an end to the weak-bank/weaksovereign vor­tex. Un­for­tu­nately, with the na­tion­al­i­sa­tion of Por­tu­gal’s Banco Espir­ito Santo, ques­tions are again swirling about the size of the hair­cuts debt-hold­ers will have to take in the event of bank bank­rupt­cies, and how much of the losses should be borne by overly in­debted tax-pay­ers.

Still, what is in­ter­est­ing about the re­cent pull-back is that, un­like last summer’s ta­per tantrum or the 2010-12 summer sell-offs, this time around Asian eq­uity mar­kets seem to be tak­ing it all in their stride. Last month, Chi­nese eq­ui­ties were up 6.6% (partly on the back of Chi­nese bank re­cap­i­tal­i­sa­tion and RMB strength), while Korea’s Kospi broke out to new postcri­sis highs. This re­silience of Asian mar­kets in the face of weak Western mar­kets and widen­ing spreads is im­pres­sive. It also com­forts us in our be­lief that the re­cent pull­backs may not be linked to any struc­tural prob­lem with global growth per se, but in­stead may be a di­rect con­se­quence of a post-ta­per­ing repric­ing of as­sets and/or an ac­knowl­edge­ment by mar­kets that the eu­ro­zone economies re­main struc­turally chal­lenged.

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