Many investors we have spoken with lately seem to be reluctantly bullish on corporate bonds. They point to stable and improving underlying fundamental trends in credit metrics and a strong underlying bid for bonds as many fixed-income investors continue to put cash to work. Nevertheless, they are increasingly concerned about the dire events unfolding in Europe.
Credit spreads widened slightly over the course of last week as both the Morningstar Corporate Bond Index and Morningstar Eurozone Bond Index widened 2 basis points to +218 and +241, respectively. However, the 2-basis-point move masks significant intraday volatility in the corporate bond market. The day-to-day rumours radiating from Europe regarding what the European Union will or will not do have been causing wide swings in credit spreads (especially in the banking sector). Portfolio managers are once again in the position where they need to analyze the probability and severity of systemic contagion and incorporate their view of that risk into their portfolio management decisions.
The tide of systemic risk is rising in Europe, and liquidity is once again tightening across the globe. Politicians and pundits are beginning to manage the market's expectations that Greece will exit the eurozone and the precedent that sets for other peripheral nations. Spain's deficit is worsening as its economy struggles and the government bails out the country's third-largest bank, Bankia. Adding fuel to the fire, S&P and Moody's have been actively downgrading Spanish banks, in some instances to below investment grade, indicating that Bankia will not be the last bank to require capital from the Spanish government.
Economic reports in the United States continue to indicate relatively benign growth prospects domestically in the face of rapid deterioration in Europe and further slowing in emerging markets. In the US, retail sales remained near the top of their recent range and the housing market showed some semblance of recovery as new home sales, existing home sales, and home prices rose. While encouraging, one month does not make a trend, and the improvement is off of extremely low absolute levels.
The HSBC Flash China Manufacturing report continued to decline, dropping to 48.7 from 49.3, the seventh month in a row it has been below 50. The eurozone composite PMI fell to 45.9 from 46.7, its lowest level since June 2009, and the manufacturing component was knocked down to 45 from 45.9. As the Chinese and European economies slow, we are seeing a domino effect as countries whose economies have relied heavily on commodity exports, such as Brazil and Australia, are quickly reducing their short-term interest rates to buffer their own slowdowns.
We could see a wild ride in the markets this week based on the plethora of economic indicators due to be released. On Wednesday we will see the US Challenger job-cut report. Thursday will bring the US ADP employment report, the first revision to first-quarter GDP, and US weekly initial jobless claims. Friday will wrap up the week with US auto sales, the American employment situation, US personal income and outlays, and the US ISM Manufacturing Index. All of these data points could easily move markets.
Markets Will Force EU to Address Systemic Risk Sooner Rather Than Later
The fear of systemic risk emanating from the European sovereign debt markets continues to weigh on corporate bonds markets. The yield on Spain's 10-year bond ended the week off its high, but at 6.31% it is still well above the market's 6% psychological hurdle rate. The spread over German bonds rose to a new high of +494, and with the yield on the 2-year bonds rising to 4.34% from 4.17%, the 2/10s credit curve flattened to +197. Conversely, Spain's 5-year credit default swap retreated slightly to +548 after hitting +560 the prior week. The CDS had led the movement in the cash bonds since the beginning of April. At this point, we are uncertain if this is just an adjustment of the basis between the bonds and the derivatives, or if this is an indicator that the market may be finding support at these levels. Italian bonds held their own as the market fixated on the situation in Spain.
