gipa69
collegio dei patafisici
In a research note published overnight, senior analysts at Barclays Capital provide a balanced assessment on the current state of play in the markets with their ‘Observations on Recent Market Turmoil’:
Problems in the structured credit markets are still unfolding, and it is hard for anyone to know when it will end or how much damage will ultimately result.
A significant deterioration in the underlying credit quality of sub-prime mortgages started this process, but it is having spillover effects on other credit products (in many cases, with strong underlying credit quality) such as CLOs, as investors have become more discriminating and risk averse. These effects could extend to other markets such as CMBS, even though the underlying credit quality is significantly stronger than in sub-prime (much like what has occurred in the market for leveraged loans).
It seems clear that the credit bubble has burst and that the peak in the easy-credit cycle is behind us. When the dust settles, activity associated with the surge in structured credit transactions will surely be lower and spreads wider. We will not return to the conditions that prevailed before the bubble burst for some time - perhaps not until the next business cycle. Under current conditions, overshoots in at least some markets are inevitable, and this will create profitable opportunities. That said, this episode will probably end up best characterized as a re-pricing of risk to more normal levels, from credit conditions that were extraordinarily (some might say excessively) easy. In other words, credit conditions are unlikely to settle into an environment that is truly restrictive.
Global Economy Should Hold up Well
While there has been considerable speculation that the bursting of the credit bubble either reflects or will cause a significant weakening of the global economy, we do not believe this to be the case. The US housing market has been and continues to be severely affected by the significant deterioration in sub-prime credit. That said, the biggest economic hit from housing is behind us: residential construction has subtracted about a full percentage point from US GDP growth over the past five quarters, and it is likely to subtract less than half of a percentage point in the second half of this year. The rest of the US economy - as well as the global economy overall - remains quite strong. There has also been speculation that the dramatic reduction in structured credit will impair capital spending, but this is also unlikely. The surge in structured credit did little to spur capex, and its unwinding should not crimp such spending. Indeed, capital spending has been surprisingly weak over the past year, just as structured credit transactions were at their peak. Many of these transactions involved leverage upon leverage, and to the extent that this was funding spending, it appears to have been on share buybacks or companies. Finally, it is worth noting that recent market turmoil has resulted in bond yields more than 50 bp lower than they would have been had this incident not occurred, which is providing some offset.
Mortgage financing has, of course, slowed significantly as a result of the recent re-pricing of credit risk. That said, it has not disappeared, even in the sub-prime sector. It is worth noting that the surge in sub-prime mortgage lending was associated with a significant reduction in the share of FHA mortgage loans, which are designed to be extended to low-income individuals. It is likely that the FHA will pick up some of the slack now, offering ways for borrowers to refinance and avoid foreclosure. A number of states are also engaged in helping sub-prime borrowers avoid foreclosure, in some cases by extending maturities, and the GSAs will probably get involved in purchasing sub-prime mortgages as well. Meanwhile, there has been virtually no effect on the prime mortgage market, as the rise in spreads there has been fully offset by the significant reduction in Treasury yields, leaving mortgage rates little changed. Moreover, household income growth remains strong and unemployment low, providing a floor to demand.
Equity Bath Unlikely at This Point
Equity markets are likely to hold up reasonably well. Corporate fundamentals remain quite strong, reflected in healthy balance sheets and very low default rates. Large-cap valuations remain attractive on an absolute basis, as well as relative to those of small- and mid-caps (although with merger activity likely to slow in response to tightening credit conditions, the bid for “digestible” companies - mostly small- and mid-cap - is likely to fade). There is also much less leverage associated with equity than credit markets. Financial innovations such as ETFs, for example, involve little leverage and are quite transparent.
Fed Easing Only If “Systemic” Risk Develops
We believe that a Fed ease remains unlikely. Of course, it would respond to a “systemic” risk, that is, one in which the financial payments system is threatened. While further losses and risk aversion could make such an event possible, it is not our best guess at this time. Indeed, the Fed would much rather avoid an ease, as inflation remains its predominant concern at a time when the dollar is still weak.
Risks
Of course, as in all such episodes, there are significant risks to this relatively benign scenario. One is how regulators and ratings agencies will respond. There is little doubt that regulators will be looking closely at this episode, especially as it involved significant credit provision by banks. Although the scrutiny might not be as intense as it was following the bursting of the equity bubble in 2000 (since the retail investor is much less exposed to structured credit than to equities), there is a significant probability that regulators will eventually take some action that could crimp activity. Meanwhile, the ratings agencies were late in downgrading many credit products, and may react aggressively as a result, which could well exacerbate current problems.
While concerns about a possible spread of credit problems will dominate markets in coming days, we believe the biggest risk may be inflation. Headline inflation has been rising over the past few years, to a large extent in response to the outstanding performance of global growth. Energy prices have been increasing significantly for years, and now food prices are accelerating as well. So far, “core” inflation has been relatively well behaved, which has prevented central banks - even in the US where the expansion is most mature - from becoming truly restrictive. If this changes and inflation concerns become more pervasive, the market consequences would be quite severe and extend beyond credit markets to virtually all those around the world that have benefited from the pro-growth policies of central banks.
Problems in the structured credit markets are still unfolding, and it is hard for anyone to know when it will end or how much damage will ultimately result.
A significant deterioration in the underlying credit quality of sub-prime mortgages started this process, but it is having spillover effects on other credit products (in many cases, with strong underlying credit quality) such as CLOs, as investors have become more discriminating and risk averse. These effects could extend to other markets such as CMBS, even though the underlying credit quality is significantly stronger than in sub-prime (much like what has occurred in the market for leveraged loans).
It seems clear that the credit bubble has burst and that the peak in the easy-credit cycle is behind us. When the dust settles, activity associated with the surge in structured credit transactions will surely be lower and spreads wider. We will not return to the conditions that prevailed before the bubble burst for some time - perhaps not until the next business cycle. Under current conditions, overshoots in at least some markets are inevitable, and this will create profitable opportunities. That said, this episode will probably end up best characterized as a re-pricing of risk to more normal levels, from credit conditions that were extraordinarily (some might say excessively) easy. In other words, credit conditions are unlikely to settle into an environment that is truly restrictive.
Global Economy Should Hold up Well
While there has been considerable speculation that the bursting of the credit bubble either reflects or will cause a significant weakening of the global economy, we do not believe this to be the case. The US housing market has been and continues to be severely affected by the significant deterioration in sub-prime credit. That said, the biggest economic hit from housing is behind us: residential construction has subtracted about a full percentage point from US GDP growth over the past five quarters, and it is likely to subtract less than half of a percentage point in the second half of this year. The rest of the US economy - as well as the global economy overall - remains quite strong. There has also been speculation that the dramatic reduction in structured credit will impair capital spending, but this is also unlikely. The surge in structured credit did little to spur capex, and its unwinding should not crimp such spending. Indeed, capital spending has been surprisingly weak over the past year, just as structured credit transactions were at their peak. Many of these transactions involved leverage upon leverage, and to the extent that this was funding spending, it appears to have been on share buybacks or companies. Finally, it is worth noting that recent market turmoil has resulted in bond yields more than 50 bp lower than they would have been had this incident not occurred, which is providing some offset.
Mortgage financing has, of course, slowed significantly as a result of the recent re-pricing of credit risk. That said, it has not disappeared, even in the sub-prime sector. It is worth noting that the surge in sub-prime mortgage lending was associated with a significant reduction in the share of FHA mortgage loans, which are designed to be extended to low-income individuals. It is likely that the FHA will pick up some of the slack now, offering ways for borrowers to refinance and avoid foreclosure. A number of states are also engaged in helping sub-prime borrowers avoid foreclosure, in some cases by extending maturities, and the GSAs will probably get involved in purchasing sub-prime mortgages as well. Meanwhile, there has been virtually no effect on the prime mortgage market, as the rise in spreads there has been fully offset by the significant reduction in Treasury yields, leaving mortgage rates little changed. Moreover, household income growth remains strong and unemployment low, providing a floor to demand.
Equity Bath Unlikely at This Point
Equity markets are likely to hold up reasonably well. Corporate fundamentals remain quite strong, reflected in healthy balance sheets and very low default rates. Large-cap valuations remain attractive on an absolute basis, as well as relative to those of small- and mid-caps (although with merger activity likely to slow in response to tightening credit conditions, the bid for “digestible” companies - mostly small- and mid-cap - is likely to fade). There is also much less leverage associated with equity than credit markets. Financial innovations such as ETFs, for example, involve little leverage and are quite transparent.
Fed Easing Only If “Systemic” Risk Develops
We believe that a Fed ease remains unlikely. Of course, it would respond to a “systemic” risk, that is, one in which the financial payments system is threatened. While further losses and risk aversion could make such an event possible, it is not our best guess at this time. Indeed, the Fed would much rather avoid an ease, as inflation remains its predominant concern at a time when the dollar is still weak.
Risks
Of course, as in all such episodes, there are significant risks to this relatively benign scenario. One is how regulators and ratings agencies will respond. There is little doubt that regulators will be looking closely at this episode, especially as it involved significant credit provision by banks. Although the scrutiny might not be as intense as it was following the bursting of the equity bubble in 2000 (since the retail investor is much less exposed to structured credit than to equities), there is a significant probability that regulators will eventually take some action that could crimp activity. Meanwhile, the ratings agencies were late in downgrading many credit products, and may react aggressively as a result, which could well exacerbate current problems.
While concerns about a possible spread of credit problems will dominate markets in coming days, we believe the biggest risk may be inflation. Headline inflation has been rising over the past few years, to a large extent in response to the outstanding performance of global growth. Energy prices have been increasing significantly for years, and now food prices are accelerating as well. So far, “core” inflation has been relatively well behaved, which has prevented central banks - even in the US where the expansion is most mature - from becoming truly restrictive. If this changes and inflation concerns become more pervasive, the market consequences would be quite severe and extend beyond credit markets to virtually all those around the world that have benefited from the pro-growth policies of central banks.
