Credit
A repricing of risk in credit markets
The credit market began the quarter poorly as near-term liquidity and funding pressures reached record levels. As market participants began to sell, this caused a significant oversupply and a dramatic repricing in credit risk followed.
The ongoing deterioration in credit markets forced central banks and governments to adopt a series of extraordinary measures to restore liquidity and market confidence. These included capital injections, rate cuts, government guarantees on bank deposits and wholesale lending, purchases of illiquid securities and fiscal stimuli.
The biggest concern for all market participants is a lack of market liquidity. This is further intensified by investors’ reluctance to redistribute capital in assets with some risk, despite the real returns from risk-free assets being very low (if not negative in some major economies). Because the market remains risk averse and illiquid, fundamental valuation techniques remain predominantly ineffective. However, credit spread levels are historically cheap.
Despite this sombre backdrop, the extraordinary remedial actions taken by central banks and governments are now beginning to gain traction. These actions have alleviated the counterparty credit risks from trading in unsecured interbank money markets. They have also started to flow through to the wholesale funding markets in the form of lower cost bank credit.
By addressing liquidity stresses and strengthening capital positions, confidence is being restored in the financial system. However, Australian credit spreads still ended the December quarter wider due to the magnitude of the global market dislocation following September’s collapse of Lehman Brothers and global year-end stresses.
The outlook for credit markets will be dominated by a shift away from forced selling, illiquidity and financial market strains to the prospect of economic weakness. The threat of weakening corporate fundamentals remains at the fore as we are still in the early stages of an economic downturn. However with governments aggressively implementing expansionary monetary policy, combined with extraordinary fiscal stimuli, the downside risks remain limited.
Looking longer term it is impossible to ignore the fundamentals, with credit prices now reflecting the current doom and gloom. This will provide compensation for investors who hold their investments to maturity, as long as no unforeseen events occur. Technicals will remain an issue in the early part of 2009, however, it is expected that as the demand-supply imbalance normalises, spreads should become more reflective of their fundamental valuations.
Our outlook remains cautious, as we believe that these developments will take time to occur. Also, there are still short- to medium-term downside risks as the full impact of persistent deleveraging spreads to the real economy. As a result we continue to position our portfolios defensively and selectively take advantage of opportunities based on key fundamental drivers.
