So much for the crisis of capitalism. It seems only yesterday that certain sections of the commentariat were falling over themselves to declare that the capitalist system was dead and we were moving into a new epoch. Governments had saved the day and the global economy was about to undergo a radical transformation. Markets would be tamed, post-Bretton Woods liberalisation reforms would be rolled back and the political consensus would shift leftwards.
The recent European elections showed that the electorate is not looking to the left for leadership. Regulatory reforms are underway, though the fading momentum is palpable. And this week we saw that the driving force of capitalism – the profit motive – is alive and well. Credit and equity markets have continued to rally on the back of better than expected earnings reports, both in Europe and the US. Animal spirits are back, and risk aversion is in the ascendancy.
Nowhere is this more evident than in the credit curve. It has been noted in previous reports (Markit Credit Wrap 22/5/09, 19/6/09) that European curves were normalising, i.e. five-year spreads trading tighter than ten-year. Back in May only a small minority of curves (about 30) had “positive shapes”. This rapidly increased to around 100 in June, with the distribution of names spread across sectors (they were previously concentrated in communications and technology).
This trend has accelerated in tandem with the strong rally of the last two weeks. There are now around 190 names trading with positive shape curves, nearly double that of a month ago. Again, most sectors have seen an increase, with the exception of materials. Financials have overtaken communications & technology as the sector with the most positive shape curves. Nearly all of the major banks in Europe have seen their curves normalise, reflecting robust quarterly earnings and favourable industry conditions.
Industrials and consumer cyclicals, two sectors damaged badly in the recession, have see their fortunes improve in recent weeks. The former has been helped by signs that industrial production is stabilising in Europe and North America, though the signals are tentative. Invensys, a British engineering group, provided another reason for optimism today. The company joined the ranks of the “rising stars”, an exclusive group in the current climate. The firm was upgraded to investment grade by S&P, the rating agency citing the firm’s improved credit fundamentals.
The turnaround is reflected in two of the most cyclical sectors – auto and retail. German car makers curves were steeply inverted for most of this year. Now, the likes of Volkswagen, BMW and Daimler are trading with normal curves. Even Fiat, with a junk-rated credit profile, has seen its curve normalise. As have Next and Kingfisher. The two UK retailers saw their credit profiles come under severe pressure in Q4 2008 and the beginning of this year. But the perceived stabilisation in the economy and improved results have pushed spreads in the sector tighter.
Perceived stabilisation? Today’s UK GDP figures, showing a contraction of 0.8% in the second quarter, cast doubt on that view. True, it was an improvement from the abysmal Q1 figures, but it was significantly worse that the consensus estimate. Some had even predicted a return to growth. The negative surprise highlighted the potential stumbling blocks for the current rally. The green shoots were withering some weeks ago and have yet to return in any meaningful way. Another busy earnings schedule next week could produce some nasty results ( Microsoft’s figures today were disappointing). Better than expected headline results from banks obscured worryingly large increases in loan loss provisions. The coming months are likely to hold further pain for the capitalist system.
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.