Markets are crippled with fear. European stocks have plummeted. Volatility gauges have spiked. Amid a political vacuum in Greece, the future of the eurozone hangs in the balance - and investors are firmly risk-off. So how can fear-soaked investors navigate the storm - other than cash-under-the-mattress strategies? A Credit Suisse strategy report today proffers some advice:
German CDS spreads: German CDS spreads are lower than they should be given the rise in Spanish bond spreads or the fall in German 10-year bond yields (Germany sees its bond yields and CDS spreads move in opposite directions during crisis episodes, as bond yields are pushed down by safe haven flows, while CDS spreads move up, as markets expect that Germany will either have to commit further resources to bail out the periphery or will have to deal with the fall-out on its commercial banks balance sheets). We would agree with our European credit strategists who recommend buying protection on Germany and selling protection on Spain.
The euro should fall: Euro-area risk indicators suggest the euro has downside from current levels, with the spreads of the average Euro-area bond yields over German bond yields, for instance, pointing to a weaker euro. Similarly, the relation between the Euro TWI and the ECB balance sheet as well as that between the /$ and Euro-area lead indicators relative to those in the US all suggest the euro should be considerably weaker.
Credit looks more vulnerable than equities: While we see that the performance of credit as an asset class has been supported by the low yields on government instruments (pushing investors looking for yield up the risk curve) and by the ECBs provision of liquidity (which reduces default risks), we still think credit is likely to underperform, for the following reasons: The Euro-area is already close to a recession (with manufacturing PMI new orders consistent with minus 1% GDP growth) but implied speculative default rates, at 4%, are considerably lower than the realised default rates during the past two recessions (10%+); The main driver of the outperformance of credit versus equities has been the fall in German bond yields and, as we have argued above, we think bond yields have upside risk from here; Inflows into corporate credit funds, which had been strong, have now slowed, according to data provided by EPFR Global.
Interestingly, CS reckons that Bund yields could actually rise - even in a risk-off environment. Here''s the rationale:
But we think that three issues ultimately argue against Bunds: ■ Germany is going to have pick up some of the bill for peripheral Europe;■ We think that there is a strong chance that ultimately we end up with some form of de facto capital controls if the crisis were to worsen (i.e. banks informally make it hard to take deposits out of bank accounts in the periphery or insurance companies are told they can only hedge local liabilities by buying their national sovereign bonds).■ Germany looks set to enjoy a period of strong growth, making real Bund yields rather unattractive to domestic investors as inflation is set to rise.Without the euro, we believe that appropriate short rate in Germany would be 2.5% and this in turn would imply an ex euro fair value of the Bund yield of 2.5%+."
|It continued: |
"We halve our underweight of Continental European equities: sentiment indicators suggest high stress (but not quite at May 2010 levels); there are signs that policy makers are willing to allow higher inflation in the core, to stimulate growth and to postpone fiscal tightening. We think there is only a 15% probability of a Greek exit by year-end. Yet, valuations remain mixed. ■ We stay underweight banks in spite of attractive valuations, not least as they tend to underperform into a weaker euro. There is potentially interesting risk/reward in non-EMU banks (domestic UK and Swedish banks).■ Dividend swaps look attractive."