The second quarter of 2009 brought us the first sustained market rally since the onset of the credit crisis in the summer of 2008. The resurgence of confidence is to be welcomed even though it has sparked considerable debate about whether or not it is entirely justified given the constraints of the longer-term outlook:
- Significant economic overhang from the financial turmoil of the last twelve months
- Uncharted territory in terms of government involvement in the private sector
In almost every respect, the 08/09 crisis and recession has rewritten the rule book. Although it is far easier to tie default cycles to recessions than refinancing/liquidity cycles, it is the latter that dictates their severity and longevity. Because the volume of corporate lending undertaken during the 2004-2007 period was done with few strings attached (covenant-light and very little regulatory oversight), the default rate has been slow to rise in this cycle, in contrast to the pattern seen in previous cycles. That said, the coming maturity schedule is daunting; unless credit markets loosen considerably, expect defaults to increase markedly next year.
Successful government intervention to stabilize credit markets and ensure funding for banks has turned last year’s fear into this year’s greed. Evidence can be seen most readily in the return of risk taking as high yield debt markets lead year-to-date performance. The decline in credit market reliance on government guaranteed funding – from declining usage of CPFF in the commercial paper market to the recent rise in non-guaranteed debt issuance from banks – points to a return of risk taking in credit markets coinciding with and contributing to a broader confidence in financial markets. However, the decline of usage of government guarantees may simply reflect the realization of a now enshrined “too big to fail” doctrine. With support programs remaining in place, the shift of risk to the public sector simply leaves private credit holders a “heads I win, tails you lose” proposition that encourages their risk taking.
Inflation will continue to trend lower as resource utilization remains extremely low, though upside surprises could appear as many states are considering sales and excise tax hikes to close large budget shortfalls. On the other hand, U.S. dollar weakness should underpin commodity prices, especially energy and soft commodities. The depreciation of the U.S. dollar against an increasing number of currencies may be the catalyst for a renewed up-leg in raw material aggregates. Energy and soft commodities are particularly well positioned to benefit. Dollar depreciation is a plus for commodities in a number of ways: it is bullish for commodity consumers outside of the U.S., it is bearish for commodity supply and it encourages a portfolio shift into “real assets”. Sustaining the recent uptrend in commodities will mostly depend on at least a modest economic recovery.
Much talk about economic “green shoots” will turn out to be weeds. In reality the rally will stall for a few weeks and the lack of upward momentum will ultimately cause sentiment to turn more negative. Focus will probably turn more to the longevity of the recovery, as the “V-shaped” theory of a quick economic resurgence seems to have little support. Many high profile pundits and indeed government spokesmen have been talking of recovery in terms of years rather than months and this dynamic means there will still be a number of weak firms that are going to face major difficulties in the next 18 months, which may turn the market more risk adverse.
Michael Ashley Schulman, CFA
Hollencrest Capital Management