For most of the year, the corporate bond market has been sceptical of the equity market's relentless march higher as credit spreads have been range-bound for most of the year and were slightly wider year to date through the first week of April. However, it appears credit investors finally capitulated, as credit spreads ripped tighter last Monday and Tuesday. However, while the S&P 500 has run up 11.4% year to date, seemingly impervious to any negative headlines, the Morningstar Corporate Bond index has only tightened 2 basis points this year, much less than one would expect as the S&P hits new highs. In fact, all of the tightening year to date occurred last Monday and Tuesday, when credit spreads tightened 5 basis points across the board.
We have heard two different explanations of why the credit markets finally decided to strengthen along with equities. The first story is that fund managers have been sitting on cash, waiting for better levels (wider spreads) to begin putting money to work. These investors finally relented and began to bid up bonds, given the continual inflow of funds and the increasing percentage of cash in their portfolios. This buying pressure was further exacerbated by dealers who were reportedly short credit and needed to cover their positions as bonds began to rise. The other story is that there were large buyers emerging from Asia who were selling yen-denominated assets and using the proceeds to rotate into US dollar-denominated assets, including corporate bonds. We don't know which narrative is accurate, but like any market chatter, there is probably a bit of truth to both.
We continue to view the corporate bond market as fairly valued at current levels, but will be analysing earnings and guidance closely this week and next for clues as to the direction of credit risk through the rest of this year.
Dimming Economic Outlook in Italy Supports Our View
On April 10, the Italian government revised its expectations for debt/GDP levels in upcoming years. The technocratic government, led by Mario Monti, now calls for a debt/GDP ratio of more than 130% and 129% for 2013 and 2014, respectively. Both of these numbers are significantly higher than the 126% and 123% for 2013 and 2014, respectively, projected late last year. The 2013 projection demonstrates the continued deterioration of the Italian economy, as the final debt/GDP ratio for 2012 was approximately 127%. Interestingly, the annual budget deficit for 2013 was projected to be 2.9%, within the European Union's 3% limit. The key issue is that with no real economic growth, the annual budget deficits add directly to the growth in the debt/GDP ratio.
The announcement by the government is no surprise to us, as we have had a more bearish view on the Italian economy for some time. This stance can best be seen in our credit ratings of the Italian banks, Intesa Sanpaolo (ISP) and UniCredit(UCG), which are two to three notches below those of the rating agencies. Also, last month we pointed out that non-performing loans in Italy are still increasing, with no sign of a slowdown in the rate increase. We continue to expect that with the continued problems throughout Europe, and with Italy's austerity programme still in place, the Italian economy will remain troubled. Italian real GDP has been negative for the past six quarters, and while we could see one positive outlier quarter in the next couple of years, we expect that on a year-over-year basis there will be effectively no real growth in Italy. With this in mind, we find it hard to imagine that the current debt/GDP projection of 129% for 2014 can be met, and we expect this projection to increase in the next year. With no government consensus achieved in the last election and with the extreme distress in the Italian economy, our outlook on the credit of Italian banks remains poor.
