Federal Reserve chairman Alan Greenspan’s recent words on the state of the US economy, as part of his semi-annual testimony to Congress, appear to have been well received. His customary care with the choice of words has a tendency to soothe even the most jittery of markets and this particular speech was no exception. “Cautiously optimistic” sums it up.
The US equity market, and also those of Europe and the UK, had already been enjoying a good run and his gently upbeat remarks added to the general happy mood. While not traditionally the best of news for fixed income markets, news that economic activity is picking up is just what corporate debt holders want to see and hear.
Credit markets have been doing very well since their nadir last autumn and, while not quite keeping up with stock markets, have certainly outperformed government bonds and spreads have narrowed markedly. Most recently, corporate spreads have held static even as equity markets faltered – a most welcome change to the volatile behaviour of previous months.
Christophe Tamet, in charge of credit at Fortis Investment Management in Brussels, agrees with the venerable Greenspan’s positive slant. “He was definitely not so negative this time. We seem to be at the bottom of the cycle and at the stage where we know the recovery will happen. The future certainly looks brighter today than it seemed in the closing months of last year, and the situation is less confusing.
“Through November and December of last year it really was very difficult to trade, many market-makers did not want to take positions and were thinking of closing their books. It was a tough time for end investors as a result. But, since January the liquidity has improved and is quite good now. And we think there are a lot of quite attractive valuations out there. We are slightly underweight AAAs, market weight AA/A and slightly overweight BBB. There is little tightening to go for in the AAA band and they are tightly correlated to the swap spread, which could widen. For a BBB issue, however, there is sufficient protection if swap spreads widen and ample scope for it to tighten should the recovery gain momentum.”
For João Zorro, head of fixed income at ESAF in Lisbon, that the US economy is on the road to recovery is not in doubt, but where he is nervous is in what he sees as the market’s blind assumption that that road will be quite smooth. “I think it is always a possibility that a recovering economy might suffer a double dip. It would be dangerous to assume that nothing unexpected can happen.
“If we look at the US, it is easy to see that there is some sort of a recovery under way. But how much of this is due to inventory rebuilding? What happens when the stock is there? Companies are still restructuring and cutting back on investment, consumer confidence is still a bit frail. We are watching carefully. However, for the moment we do agree that the market is right to be discounting the recovery picture. And we are overweight credit and underweight governments.”
For its government positions, ESAF is positioned for curve flattening and as such is overweight in duration terms. On the other hand, its credit portfolio duration is shorter than its benchmark. Zorro explains, “We are mainly in the four to seven-year area, for a couple of reasons. Firstly it is the best place to be for rolling down the curve and secondly this is where the liquidity is.”
ESAF’s credit portfolio is, according to Zorro, fairly scattered around with a general bias to financials. “This is more a technical issue,” he says. “Tier one paper is at good spreads; there is a rarity value with large buyers waiting but no sellers and very little in the offering pipeline. With spreads at 140–150 or even 160 basis points over Bunds, they are cheaper than telecoms with lower volatility, less risk and better fundamentals.”
As for the telecoms, Zorro is almost reluctant to be overweight. “We don’t like the volatility, that’s for sure, but there is not much supply, capital expenditure is declining and they do seem to be paying much more attention to us bond holders. And this sector is far and away the most liquid, it is a benchmark and it is the easiest to enter and, of course, exit.”
Tamet argues there still exists a tension to the markets, and thus care must be taken. “From our perspective, we are running very diversified portfolios with very different names. We want to avoid a big problem if one name turns sour. The risks are still there. The main risk to our reasonably positive scenario on the outlook for the global economy in general is that there will be a downward lurch before the summer. The smooth recovery is well discounted and that is why we are not overweight at the moment.”
As well as spreading their monies wider than previously, Tamet and his team are concerned that now is not the time to be taking big bets. “Be modest, that’s our advice. The accounting ‘problem’ in the US makes us nervous.” He suggests that an event like 11 September is so shocking and not one that investors or markets could be blamed for not being prepared for. It is unreasonable to go through life preparing for an event like it. “11 September happened, the authorities rose to the occasion and dealt with it and the rest of the world has to carry on. But this Enron affair is different because it has raised the possibility that we had not identified some of the risks we had in our portfolio and that is uncomfortable and something we should deal with.”
So Tamet is advocating extra care on US names, whatever the denomination of the issue. “When there is a general review of these things in the US whatever agreement is reached, it might mean good news for some companies and bad news for others and until we know which are which we prefer to remain cautious.”