State of the Market

Extreme volatility is one of the most successful means to destroy capital. As evidenced by the recent debacle in London, the constant reversals can produce calamitous results on trading desks. Consequently, dealers are reducing positions and widening out bid-ask spreads. In contrast to the 2008 crisis, when the problems were driven by concerns over the private sector, due to the over-leverage of U.S. households, this crisis is propelled by anxieties about the public sector. In 2008, U.S. banks were overly exposed to mortgage securities, thus forcing them to take large losses and recapitalize. Now, the European banks are subject to the unsustainable levels of debt issued by the peripheral European governments. As a result, they are facing huge losses and also need to recapitalize. Nevertheless, the buyside remains strong. In comparison with 2008, the amount of leverage in the financial system is low. There has been no deluge of margin calls as bond prices gapped down. Hence, there was no panic selling. Most of the declines in prices were caused by dealers backing down their bids, as they lightened their balance sheets. With a few notable exceptions, most fund managers were well prepared for the downturn. Cash levels are high, and some PMs are itching to step back into the fray. Valuations are extremely attractive. There is a wide range of strong credits that are trading with double-digit yields. Yet, no one wants to take a punt. There is fear that the market could still get worse, and who wants to catch a falling knife?

The list of concerns is long. In addition to worries about Greece and the peripheral European countries, there are deep-seated fears about the health of the European financial system. U.S. banks are cutting their exposure to continental institutions, forcing them to run to the ECB for liquidity. The collapse of a major European bank could easily overwhelm some of the Triple A-rated countries and create an Irish-like crisis, when they were forced to nationalize some of their biggest lenders. This would most likely result in a down-grade and bring new pressure on the euro. There are also concerns about the U.S. economy, but we are more constructive on its outlook. As we argued before, the U.S. economy is in much better shape than most people acknowledge. Last week’s GDP growth and employment numbers confirmed this fact. The pickup in capital investment also acknowledged the strength of the U.S. economy. Unfortunately, the upcoming political showdown for the reduction in government expenditures is causing apprehension. The Republicans, Democrats and Tea-Party are in no mood to negotiate or compromise. Therefore, the outcome will not be pretty. The fiscal retrenchment of the U.S. public sector, both at the federal and municipal levels, will produce a drag on economic activity. Nonetheless, we believe that this will be better for the nation in the medium to long run. The U.S. is in the midst of a profound restructuring, and it should emerge stronger than before.

Likewise, there is nervousness about the health of the emerging market countries. At first glance, they appear to be in good shape. GDP growth is strong and most of the countries have high levels of international reserves. However, much of the economic activity across the emerging world is driven by private consumption. Unfortunately, consumer credit and appreciating currencies are the main drivers of the consumer boom, which means that it is vulnerable to a reversal in external conditions. These issues permeate the mind of investors, and help explain some of the hesitation in picking up paper. Nevertheless, emerging market corporate balance sheets remain strong. Many companies tapped the capital markets during the first half of the year, and find themselves in good shape. Not surprisingly, the biggest declines were registered in the lower-rated credits. High-Beta plays in Argentina and the Chinese property sector fell sharply. Many of the more speculative credits in Eastern Europe and Mexico also suffered enormously. Investors used the correction as an opportunity to pick up better rated credits in Chile, Colombia and Trinidad and Tobago.  Still, opportunities abound. The bonds issued by Province of Buenos Aires, for example, are yielding more than 16%. Strong Brazilian issuers are providing double digit returns, and a Panamanian property developer is offering yields of almost 40%. The state of the market is a mixed one. The dealers are weak, the buyside is strong and the credits are sound. People may be worried about the volatility, but the returns are sufficiently compelling in order to take a much closer look.