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EUROPEAN DEFAULTS ON THE RISE

A new report out of Moody’s is predicting a junk bond default rate as high as 30% in Europe.

“With a deteriorating economic environment, poor corporate results, and restricted access to liquidity for the more vulnerable companies in Western Europe, we believe the acceleration in defaults that occurred in the fourth quarter of 2008 will continue through this year and possibly into 2010.  We also believe that debt-financed leveraged buyout transactions (LBOs) will be at the forefront of this increase.  As a result, we calculate that between 90 and 112 Western European firms on which we have either a public rating or a credit estimate in the speculative-grade category could in our opinion default in 2009.  This would represent a default rate of between 11.7% and 14.7% for our universe of 765 corporate ratings and credit estimates. What’s more, the default rate could remain in the same range in 2010. Our previous estimate, published in December 2008, indicated a range of 8.7% to 11.1%.”

This is in-line with expectations in the U.S. where Moody’s expects defaults to peak in Q4 or Q1 of 2010.  As we’ve previously written, default rates have proven to be a relatively accurate predictor of bear market bottoms.  This makes sense as the peak in bankruptcy concerns during a recession would coincide with the max fear point a bear market (obviously, stocks going to zero are a good reason to sell).  With defaults expected to shoot higher heading into the end of the year I think it’s safe to say that the risks to this rally are abundant.

7 comments
  1. Avatar
    Cullen Roche

    They were essentially what I expected. I haven’t run the numbers on JPM, but they’re being almost as conservative in their mark-downs as the other banks. If JPM marked their non-performing assets to market my research shows that they’re worth about 50 cents on the dollar. That means they’re going to have to earn their way out of this crisis. And if things deteriorate or continue for years they’re in trouble. This quarter’s results are a complete non-event.

  2. Avatar
    vfsv

    On the other hand, to the extent the market understands, “Moody’s expects defaults to peak in Q4 or Q1 of 2010,” it also seems to believe:
    1) these defaults are already “priced in” AND,
    2) since the forecasted peak time falls within the classic 6- to 9-month window by which the market supposedly leads the economy, “now” is the time to buy stocks.

    It seems the “trick” is to figure out when the market might change it’s mind.

  3. Avatar
    Cullen Roche

    The evidence on the market’s lead time is minimal at best. Anyone who bought the head fake in 2001 got their face ripped off in 2002. I don’t know where this notion that the market leads the economy comes from. In my opinion, it’s the simple fact that fears are the highest when things appear the worst. Some investors view the ensuing rebound as the market ”
    leading” the economy when in fact this “lead” time is nothing more than a mean reversion that resulted from an overly fearful market. In some cases the market happens to rebound after things appear the worst and many investors chalk that up as the market being this great forecasting mechanism. In my experience, the market is a terrible pricing mechanism and has trouble forecasting what is going to happen tomorrow and has absolutely no clue what is going to happen in 6 months…..If expectations for a recovery remain high and the economy moves sideways or lower from here we are going to see a test of the March low….

  4. Avatar
    vfsv

    “If expectations for a recovery remain high and the economy moves sideways or lower from here we are going to see a test of the March low….”
    —This is indeed the “trick.”
    —If/when expectations change &/or “less bad” data is no longer successfully spun as “good” news &/or…

  5. Avatar
    Cullen Roche

    Of course, timing is everything. But if you’re someone like me who is skeptical of the economic rebound and has the patience to wait for the government to get out of the way while sentiment boils over on the positive side we can place intelligent bets in the coming weeks or months (depending on how things progress) that are likely to end up in our favor. And if they don’t we will hedge ourselves in a manner that doesn’t cause debilitating losses in our portfolios. I have been in cash for a while now after the March 8th buy call. I expect to leg into short positions or something equivalent as the bank earnings end and the government gets out of our way with this stress test mockery. Will my timing be perfect? Of course not, but I think it will be a bet with great risk/reward after such a nice run up….In the meantime, you’re just gambling on market direction (though the bias certainly appears to be up – the risk/reward in this market is downright awful right now).

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