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Credit Wrap
August 15 2008, Markit Credit Wrap - The Week in Perspective
One could be forgiven for thinking that US economy has hit rock bottom and the worst is now behind us. Several retailers posted better then expected results this week and the consumer discretionary sector has been one of the best performers. However, this view can only be described as Panglossian, and an analysis of Markit's credit data helps reveal why. CDS spreads reached a peak in March, just prior to the index rolls. The market was unnerved by fears of systemic risk in the financial system, with Bear Stearns on the verge of failure and monolines' business model under severe stress. The number of names trading points upfront - indicating considerable near-term risk of default - increased dramatically from 30 at the beginning of the year to over 60 by March. Naturally, many of these names were financials, with the aforementioned bond insurers prominent.
Spreads subsequently tightened in the following weeks after the historically-informed actions of the Federal Reserve and other central banks helped avert a financial crisis. But the rally proved short-lived as the news from the economy became more and more dismal. Investor attention began to switch from financials - although they still provided plenty of headlines - towards cyclical names that are likely to be among the biggest losers from a slowing economy. This is reflected in the expansion of the upfront universe and its composition. Figure 1 above shows that, though spreads are tighter than in March, the number of names trading upfront has increased. Most of this increase is due to the decline of the consumer discretionary sector. Many of these names - notably homebuilders and car producers - have been in trouble for some time. However, they have been joined by less familiar names. Station Casinos (see chart above) and other names in the gaming sector have suffered in recent months due to declining consumer confidence and a slowing economy.
In Europe, the picture is somewhat different. The number of names of names trading upfront has also increased, with the seven credits in the Markit iTraxx Crossover marking a significant increase from previous months. But the composition is different from the US. The financial sector is more robust, although there are obviously still problems surrounding writedowns at European banks. The issue is not so much what sector they are in, but the relative strength of their credit profiles. Many of the names were taken private in LBOs, leaving them with weakened balance sheets. Investors have been paying more attention to cash burn rates and liquidity ratios.
Figures last week showed that Europe is following the US into a downturn, with few governments having the fiscal stimulus tools of the latter. Default rates - still fairly low - lag economic growth and will inevitably increase on both sides of the Atlantic as we enter a new phase of the business cycle.