As we make our way through earnings season, reports have been generally in line with expectations and management teams have mostly reiterated their guidance for the year. However, the economic reports that have been released over the past few weeks have taken investors on a wild roller coaster ride.
French Presidential Election Could Have Global Implications
On Sunday, socialist candidate Francois Hollande won the French presidential election against incumbent Nicolas Sarkozy. This heightens political risk in the eurozone, specifically between France and Germany. Hollande has been very critical of the European Union's response to the sovereign debt crisis, made numerous statements questioning the role of the European Central Bank, and voiced his desire to renegotiate France's financial support for the sovereign rescue funds. Under his leadership, we may see a re-emergence of political volatility in the eurozone member nations.
While there have been disagreements as to the specifics of the actions taken to alleviate the sovereign debt crisis, member nations have been working in good faith to keep the EU together. However, if Hollande tries to renegotiate many of the pacts that France agreed to under Sarkozy's tenure, we think it could undermine many of the accords that have already been established, amplify the political tension between the policymakers and ECB, and upset the political relations among many of the other members in the EU. Any one of these disruptions would probably unnerve investors.
While the political risk in France may be poised to flare up, the sovereign bond market in Europe continued to improve as the yield on Spain's 10-year bonds dropped 15 basis points last week to 5.73% and the yield on Italy's 10-year bond dropped about 20 basis points to 5.43%. As long as the yields on Spanish and Italian bonds stay contained, those countries may have enough time to implement the structural changes needed to place both on sound footing and lead them back to economic expansion.
Further Signs of Global Economic Slowdown
Australia cut its short-term interest rates 50 basis points to 3.75%, which brings the rate to its lowest level in two years. This is the third cut in the overnight borrowing rate since late 2011. This follows interest rate cuts in several emerging markets over the past few weeks, such as Brazil and India. China's official PMI report rose to 53.3, indicating that the economy continues to expand, albeit at a rate slower than consensus expectations. However, this contrasts with HSBC's China PMI Index, which at 49.1 in April indicates that the Chinese economy is contracting. HSBC's China PMI report has been below 50 since last June.
Economic indicators are just as confusing in the US as they are elsewhere. At the beginning of last week, regional economic reports such as the Chicago PMI fell further than economists expected. But the next day, the national ISM manufacturing report significantly surpassed expectations, bolstering investor hopes that the U.S. economy was holding up despite the European slowdown. In fact, not only did ISM come in higher than expected, it rose from last month, whereas economists had been expecting a fall. On Wednesday, the ADP payroll report was significantly below consensus, tempering the high hopes for strong employment growth. Investors cheered jobless claims Thursday, which fell further and faster than anyone had expected. On Friday, however, the employment situation sapped any remaining hope from the market.
Through these peaks and valleys, as it became increasingly hard to discern the economic trend, credit traders were unwilling to commit in either direction. Credit spreads stayed in a relatively tight trading band throughout the week and ended up right back where they started. The average spread of Morningstar's Corporate Bond Index was unchanged at +192, and the European Corporate Bond Index held steady at +223. Each time it appeared that credit spreads were attempting to move wider, we saw a rush to buy strong single A bonds on the dips; however, there was no follow-through to the upside as investors would not chase the spreads tighter when the economic news was positive. This highlights to us the lack of conviction in the strength of the economy, yet tells us that there is a strong technical bid for paper as many portfolio managers continue to receive cash inflows that need to be put to work.
We Remain Neutral on Corporate Credit Risk Exposure
Since we moved to a neutral view on corporate credit risk exposure April 9, the average spread in the Morningstar Corporate Bond Index is unchanged. Corporate earnings and credit fundamentals are stable to slightly improving; however, until we gain additional clarity into the impact on corporate risk because of the recessions in many European nations and the slowdown in emerging markets, we believe a neutral stance in corporate bonds is warranted.
If the situation in Europe deteriorates, the emerging markets descend into a hard landing or growth in the United States dwindles, then the contagion from heightened credit risk will hurt the corporate bond markets and spreads will widen across the board. However, if we gain additional visibility that these issues are alleviated, then we think corporate credit spreads will resume their tightening trend as stable corporate fundamentals and positive technicals provide greater demand for corporate bonds.
