We are still in the epicentre of ‘Credit Quake 08’, according to Bloomberg, while for Alan Greenspan, the former chairman of America’s Federal Reserve, we are the hapless – if not blameless – flotsam caught in a “once-in-a-century credit tsunami”. Sadly, this is not just hyperbole. What we are experiencing is unprecedented in its global scale and duration.
And, if these catastrophic euphemisms depicting the markets as a fickle force of nature were not bad enough, we have now entered a frightening phase of the quake/tsunami labelled by some as a “negative feedback loop”. Also known as a vicious cycle, this refers to the drying up of credit, which leads to increased defaults, a slowing of the economy and falling stockmarkets, which makes banks constrain lending further, which leads to mass deleveraging and economic contraction, which leads to further falls in equities, and so on.
Investors should not feel that they must simply hide under a table or run for the hills while the supply of credit remains anaemic and extreme risk aversion persists. Given the broadest of all possible remits, where should one invest?On a five-year view, most asset classes with a risk premium – equities, corporate bonds and commodities – will provide a return in excess of cash. Property, particularly in Britain, would be the exception to this rule, with property swaps on the IPD index pricing in negative total return over the five years to December 2013. If property will be the slowest to recover, where will the quickest rebound be found?The best opportunities can be found in areas of the credit and loan markets. Credit spreads have blown out to levels far in excess of previous highs and are pricing in defaults on a scale not witnessed since the Great Depression. While this outcome remains a slight possibility, this spread widening is probably more a function of massive deleveraging by highly geared investors and panic selling among other debt holders. Defaults will rise but the default rate will not come close to these implied levels.
As a result of this spread widening, investors are being paid more than 20% over the yield of equivalent government bonds to hold high-yield debt; 12% over for the subordinated debt of investment grade financials; and nearly 6% over for senior financial debt. For senior loan investors – those that are first to be repaid in the event of a default and where recovery rates are historically 70% – some issues are yielding more than 14% over cash. These coupons represent an attractive return in this environment, without taking into account the potential for capital appreciation.
It is impossible to predict when these spreads will begin to narrow, but certain areas of the credit market are set to recover before other risk assets. Financials, for example, have been hit hard in the wake of Lehmans’ bankruptcy and Washington Mutual’s demise, but these companies have since been the recipients of billions of dollars of funding commitments by governments around the world.
These companies, particularly those of systemic importance, have implicit government backing and the chances of default are slim. Moreover, they are much further advanced in repairing their balance sheets than companies in other sectors and are therefore further through the cycle.
If these spreads narrow, even just back to previous widths, the potential return is attractive, given the relatively low level of risk. Until the deleveraging and indiscriminate selling abates there may well be more mark-to-market weakness but the generous yields on offer will serve to mitigate some of this downside.Equities, meanwhile, continue to face the headwind of a potentially severe recession. In addition, equities tend to rally before the economic trough is reached. However, we are still some way off this point. Nevertheless, there are pockets of value within the equity market. The classic defensive sectors such as pharmaceuticals, utilities and food producers have held up well overall. Over the longer term, sectors such as water, alternative energy and agriculture are areas with more resilient earnings profiles, as well as good long-term growth prospects.
The sell-off in farming-related stocks has left seed and fertiliser stocks trading on good valuations. Farmers may spend less on equipment and fertiliser now that grain prices have come off their recent highs but people still need to eat and agriculture is one of the only unleveraged sectors in the world, after years of under-investment. Congruently, alternative energy and environmental stocks are at their lowest ever earnings multiples. Green stocks should also receive a fillip from Barack Obama’s commitments on renewables and the Kyoto Protocol.