The average spread of Morningstar's Corporate Bond Index and European Corporate Bond Index held steady last week at +192 and +223, respectively. Trading over the course of the week generally stayed within a very narrow band, and the new issue market was very quiet. Although we had seen a number of issuers access the capital markets after they released earnings the past few quarters, this time around investors were able to concentrate on the implications of earnings releases without that distraction.
Generally, earnings in our coverage universe have been in line to slightly stronger than expected. The few outliers to the downside appeared to represent issuer-specific problems rather than a potential slowdown in earnings momentum in general. However, many of the economic metrics and indicators released last week, specifically in the US, were softer than expected. While these metrics were below Street consensus, we think they indicate a slowly expanding economy.
Corporate earnings and credit fundamentals continue to be stable to slightly improving; however, until we gain additional clarity on the impact on corporate risk caused by the European sovereign debt crisis and the slowdown in emerging markets, we believe a neutral stance in corporate bonds is warranted. If the situation in Europe deteriorates, the emerging markets descend into a hard landing, or growth in the United States dwindles, the contagion from heightened credit risk will hurt the corporate bond markets and spreads will widen across the board. However, if we gain additional visibility that these issues are alleviated, then we think corporate credit spreads will resume their tightening trend as stable corporate fundamentals and positive technicals provide greater demand for corporate bonds.
Europe and Emerging Markets Reveal Further Deterioration
The economies of Europe and several of the emerging markets showed further deterioration. For example, in the emerging markets, the China flash manufacturing PMI indicator continued to be below 50 (indicating continuing contraction). In India (which just cut its short-term interest rates by 50 basis points two weeks ago in an attempt to spur its economy), S&P reduced the outlook on the country's rating to negative, indicating a possible rating downgrade may be in the cards. India is currently rated BBB- by S&P; therefore, if the rating were to be lowered, (which S&P stated was a one out of three chance over the next two years) the sovereign rating would fall below investment grade and into the junk category.
In Europe, the flash manufacturing PMI declined to 46 and several countries reported slipping into recession after two successive declines in GDP. The United Kingdom missed its 0.1% consensus growth estimate for first-quarter GDP, as the reported figure declined 0.2%, following a 0.2% decline the prior quarter. Spain also slipped into a recession as the Bank of Spain estimated that first-quarter GDP declined 0.4%, following a 0.3% decline in the fourth quarter.
Adding to Spain's woes, S&P downgraded the country's sovereign rating two notches to BBB+ with a continuing negative outlook. The market has long traded Spanish debt at yields that were more indicative of a sovereign with a credit rating below S&P's rating, and as such the downgrade had little effect on trading levels. Spain's 10-year bonds ended the week at 5.88% and the spread between the 2-year and 10-year was 260 basis points. The wide spread between the 2-year and 10-year indicates that even though the 10-year bonds are trading at a +418 spread over German bonds, the market is not pricing in a high probability of near-term jump-to-default risk. The greater impact of the downgrade may be among Spanish banks, whose ratings may be subsequently downgraded.
Not everything out of Europe was negative last week, though. On the positive front, Italy successfully auctioned off longer-dated debt and its 10-year bond is trading at 5.64%, well inside the 6% demarcation (which has been the yield at which the market considers sovereign debt financing to become unsustainable). As long as the yields on Spanish and Italian bonds stay contained, those countries may have enough time to implement the structural changes needed to place both on sound footing and lead them back to economic expansion.
US Economic Growth on Track for 2.0%-2.5% in 2012
While the GDP estimate released last Friday missed the Street consensus, the market largely ignored the headline figure. According to Morningstar's director of economic analysis Bob Johnson, "The quality of the report was high." A few of the factors that drove his opinion include good news in the US housing front and rising consumer spending. Bob highlighted that:
- US housing data within the GDP calculation made the second consecutive positive contribution toward expanding growth
- US consumer spending rose 2.9%,
- US consumption played a greater part in growth as the contribution from inventory was smaller than in the fourth quarter
One of the greatest drags on GDP last quarter was a 12% decrease in government spending. Without the decline in government spending, GDP would have been near the consensus estimate. Bob continues to forecast economic growth of 2.0%-2.5% for 2012 and 2013.
FOMC Statement Was A Non-Event
The Federal Reserve's recent statement was a non-event and barely registered in the credit markets. No new market interventions were hinted, and the Fed plans to finish Operation Twist (selling short-term bonds and buying long-term bonds) in June. Within the released economic forecast, the Fed slightly increased its projections for GDP growth for this year, raising the midpoint of its range by 20 basis points to 2.4%-2.9% for 2012. However, the Fed decreased the midpoint of its 2013 and 2014 GDP estimates by 10 and 30 basis points, respectively. The decrease in GDP expectations in the later years was due to the effects of further reduced government spending and the likelihood of future tax increases.
The Fed decreased its unemployment projection by 45 basis points to a midpoint of 7.9% and slightly reduced its 2013 and 2014 unemployment ranges. The Fed raised the midpoint of its personal consumption expenditure inflation forecast by 35 basis points to just under 2.0% and slightly increased the bottom of the range on its 2013 and 2014 estimates. While it may be slightly worrying for fixed-income investors to see the increasing trend in PCE at 2%, the PCE is still at the Fed's preferred target level and provides it with the ability to conduct further accommodative measures if the economy weakens.
