A typically volatile week in the credit markets ended positively, though UK investors could be forgiven if they struggled to share in the optimism. The main credittightened in the latter part of the week but still failed to recover losses from Monday and Tuesday. US banks were again the catalyst for a correction. Bank of America reminded investors that the problems of the sector are far from behind it after it revealed a sharp increase in provisions for credit losses. The bearish outlook of CEO Ken Lewis pushed banks spreads wider and weighed on the broader market. Rumours of disastrous stress test results added to negative sentiment. The source of the speculation was discredited, but the uncertainty caused consternation among investors. Clarity should be provided later today when the Treasury publishes the assumptions and methodology relevant to the the stress tests.
This bear market rally – if it is one – has proved resilient to weak macroeconomic news. So it proved this week. The annual UK budget revealed a gaping hole in the government finances and borrowing requirements unprecedented in the post-war era. Though the figures were larger than expected, they had little impact on the equity and credit markets. Investors have been more focused on the banking sector and earnings season. The pattern was replicated today with the release of Q1 GDP figures for the UK. A contraction of 1.9%, far greater than expected, was met with equanimity by the markets. The figure, representing the fastest decline in output since 1979, casts serious doubt on Chancellor Darling’s already optimistic growth projections. However, UK sovereign CDS spreads widened marginally following the news.
The chart above shows the strength of the rally and what sectors have been driving it. Financials, the instigator of the current crisis, have gained ground. Government measures to support the sector have received a cautious welcome, and earnings on the whole have been positive. Consumer services have outperformed on hopes that the monetary and fiscal stimuli implemented by the developed world’s governments will restore confidence. The sector is now trading tighter than industrials, where results have been disappointing. Despite some commentators dubbing it the “white-collar recession”, manufacturing has borne the brunt of the current downturn. It is no surprise that defensive sectors such as healthcare have underperformed in a sustained rally.
Is the rally premature? The latest report from the IMF would suggest so. The agency forecasts that the global economy will contract by 1.3% in 2009, making it the deepest post-World War II recession by a distance. A recovery is expected in 2010 but it will be sluggish. Default rates are rising and risks remains weighted to the downside, particularly in high-yield credit.
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.