“Uncertainty and expectation are the joys of life”. The English playwright William Congreve lived in times far more uncertain than our own. But he spent most of his life in high society rather than high finance, and few modern investors would concur with his sentiment. The credit markets have spent the last few weeks groping for direction. The inexorable tightening in spreads has ground to a halt, and the enemy of financial markets – uncertainty – has returned. US Treasury yields have yo-yo’d, exemplifying the tipping point the global economy seems to find itself on. One day growth is set to resume and the most urgent threat is inflation, the next investors are fretting about the withering of “green shoots”.
A trend that has maintained a semblance of consistency is the shape of the corporate credit curve. It was remarked last month (Markit Credit Wrap 22/5/09) that CDS curves had begun to normalise. The vast majority of curves were still inverted between the 5-year and 10-year points, but most were flattening and some had returned to a normal shape, i.e. 10-year trading wider than 5-year. The majority of these were in the media/telecoms sector, e.g. BSkyB, Deutsche Telekom. Several names thought as defensive, e.g. Unilever, were trading with slightly inverted curves, an unusual situation in CDS market history.
It was thought that a continuation of the rally would see more curves “normalise”, though the process could take some time. In the event, the rally has spluttered but the steepening of curves has continued apace. The chart above shows the rapid change in the shape of European CDS curves. At May 21, there were around 30 names trading with positive shape curves, the bulk of them in the communications and technology sector. Now there are around 100 names, and the distribution is spread across most sectors.
Defensive names in the consumer staples sector – consumer goods firms such as Nestle and Diageo, tobacco firms and supermarket groups – have seen their curves return to their expected shape. The aforementioned Unilever is now trading with a positive curve. There has been a large increase in the number of banks normalising, despite concerns over stress tests and new regulation. And high quality industrial names such as Siemens and TNT (see above) now have familiar-looking curves.
Will this trend continue? Systemic risk has subsided and the threat of financial catastrophe is minimal. A stabilisation of the global economy, even at a low level, should see more curves returning to their normal shape.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.