European Sovereign Credit and Banking Fears Fading, But Risks Remain
The yield on Spanish 10-year bonds rose 16 basis points last week to 4.92%, but are still 30 basis points lower than last month and near their lowest since late 2010. The yield on Italian 10-year bonds held steady at 4.60%, near the middle of its six-month trading range.
We think the continuing growth in non-performing loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks
While the markets appear relatively sanguine regarding Europe's sovereign risks, we have long held a sceptical view that Europe's structural problems have been resolved. The rating agencies also appear to be increasingly nervous about the direction of credit risk among European nations. For example, Fitch recently cut its credit rating on Italy one notch to BBB+ and Moody's downgraded the United Kingdom to Aa1 from Aaa. Fitch specifically pointed to the adverse impact on the headline budget deficit due to Italy's deep, ongoing recession. While these downgrades are not significant events in and of themselves, they may indicate that the agencies are re-evaluating their credit ratings across the eurozone. The greater risk is if this foreshadows further rating changes in other European sovereign credit ratings. Also, as we've seen before, once one of the rating agencies makes its move, it provides cover for the others to follow.
Compounding the risk for further sovereign rating downgrades, we think the continuing growth in non-performing loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks. For example, last week our bank credit analyst Jim Leonard, wrote that 
Intesa Sanpaolo (ISP) recognised an 18% year-over-year increase in gross total non-performing loans in the fourth quarter. That brought Intesa's balance of gross non-performing loans/total loans to well over 11%. Intesa points out, however, that compared with its Italian bank peers it has the second-lowest percentage, with the average percentage for Italian banks being 15.8%. These numbers are staggering, and they demonstrate how much Italy's economic slowdown has affected Italian bank loan portfolios. On its earnings call, Intesa included a slide that shows that at the end of 2011, Italian banks reported the balance of non-performing loans/total loans at 9.9%, compared with 8.5% for Spanish banks. Intesa then stated that if Spanish banks had to report non-performing loans in the same manner as required by Italian banking standards, Spanish bank non-performing loans would jump to 25.3%. While we agree that this example does demonstrate the strict standards of Italian banking, we think it even further demonstrates the dire state of the Spanish economy. We continue to take a harsh credit view on the outlook for the Italian and Spanish banks, and our average credit rating is well below the other rating agencies.
Complacency Spreads in US Markets
After 10 straight days of gains, the equity market's winning streak finally came to an end on Friday as the S&P 500 dipped modestly. The equity market's risk-on sentiment seems to be that so long as the Federal Reserve is injecting $85 billion of debt into the financial system every month, equities have nowhere to go but up. However, the corporate bond market seems more suspicious of this supposition, as corporate bonds have not participated in this rally to nearly the same degree. The average credit spread in the Morningstar Corporate Bond Index tightened only 1 basis point last week to +134 and has tightened only 3 basis points over the past two weeks.
Financials led the tightening last week as spreads with the sector contracted 2 basis points while the industrial sector was stagnant. Since the beginning of the year, our index has traded within a narrow 5-basis-point range; on a monthly basis in 2012, the index on average traded within a 15-basis-point range. Year to date, the Morningstar Corporate Bond Index has declined 0.63% as the 10-year Treasury bond has backed up 25 basis points to 2.00%, outweighing the additional return from corporate credit spread tightening.
With the VIX reaching 11.5, its lowest level since January 2007, complacency has reached new highs. With plenty of liquidity sloshing around looking for a home, any day with positive news--or even a day with a lack of news--allows asset prices to levitate. It has taken decidedly negative news to derail the seemingly impervious markets, and even then, the markets have quickly brushed off the news and quickly regained lost ground. The extraordinary level of global central bank easing appears unlikely to end anytime soon, especially with weakness experienced in emerging markets, eurozone economies in recession, and real GDP growth expectations in the United States in a moderate 2.0-2.5% range.
We view the corporate bond market as fully valued at current spread levels and expect that returns will be in the low- to mid-single-digit range this year. To generate a higher return, one would have to assume that either interest rates will fall below their already-low levels, or credit spreads will tighten toward the historically tight levels experienced before the 2008-09 credit crisis, neither of which we think will happen.
In the run-up to the 2008-09 credit crisis, an over-abundance of structured credit vehicles such as collateralised debt obligations and structured investment vehicles were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. We doubt that these structures will reappear anytime soon. With real interest rates at negative real yields for the next five years, investors would have to be willing to lock in an even greater erosion of purchasing power to drive interest rates lower. We don't expect such an outcome.
