In-between the lines

Frankfurt am Main, (PresseBox) - .
- Market sentiment stuck between central banks and economic news
- Restoration of loan market activity in the US much better than in Europe
- European high yield activity has picked up but not enough to offset loan slump

The central bank induced rally in financial markets has run out of steam. Equity markets are trading in a more volatile sideway range and sovereign spreads in the Euro periphery are no longer falling. Nevertheless, market sentiment is quite resilient, given the number of negative news, such as the credit rating downgrade of Spain yesterday and various reductions of growth forecast by official institutions like the IMF and the World Bank. We remain positive for financial markets medium term and see better growth prospects for next year, given the amount of financial stimulus applied by central banks around the world. However, the fourth quarter is likely to see more volatility. A particular issue is the deadlock around Spain. Most likely, it will have to come to another climax before Spain seeks and receives EU support and the ECB activates its OMT program.

A tale of two loan markets

To be sure, central banks cannot fix it all. One critical area is the health of the financial system. Central bank support is critical for the restoration of financial health, but more is required than just cheap money. In the US, the restoration of financial sector health is well advanced. Banks have disposed most of their bad assets, insolvent banks have been wound up and others have been recapitalized. Banks are still cautious, but lending activity is starting to pick up. The restoration of banking sector health is also a reason why the housing market has started to recover this year.

The restoration of financial health is also visible in other areas of the US financial system. A good example is the leveraged loan market. With an annual issuance volume of around USD500 billion, the leveraged loan market is an important factor in US corporate finance and the overall economy. The financial crisis caused a collapse in loan issuance, both relative to the pre-crisis peak as well as the pre-crisis cyclical average. Today, the US loan market is back in business. September was one of the best months since the crisis. The number of new deals year-to-date already exceeds last year's level. Activity is not quite back to the pre-crisis peak and spreads are wider, but issuance volumes are well above the previous cyclical average. An important factor in the recovery of the loan market, besides the general restoration of corporate and financial health, has been the growing demand by institutional investors, also through the revival of collateralized loan obligations (CLOs).

In contrast, the European loan market remains depressed. Activity recovered somewhat in 2010/11, but fell again this year and remains far below the pre-crisis peak and the previous cyclical average. Spreads have also widened relative to the US although both markets experienced a similar deterioration in average credit quality. Before the crisis, European spreads were lower than US spreads, due partly to tighter supply conditions (European loan issuance used to be about a third of US loan issuance). The withdrawal of issuers from the periphery and overseas explains some of the drop in overall issuance activity, but by far not all. The share of issuers from the periphery fell from 8.5% in 2007 to 4.5% in 2012. The share of overseas issuers fell from 11% in 2007 to 6% in 2012.

Most of the drop in activity is due to less issuance from the Euro-area core, the UK and Scandinavia, which reflects both supply and demand conditions. Corporatesector health is mostly good, but companies are cautious about new investments. Especially M&A activity is very low. Institutional demand is also weak. In particular the CLO market has collapsed and there is no sign that it will recover soon as it has in the US.

European HY bonds make up some of the gap

Some of the gap left by the leveraged loan market has been picked up by the high yield market. Compared to the US, the European HY market has been historically much smaller (just about an eighth). Issuance completely dried up in 2008, but the market recovered nicely in 2009/10 as institutional investors looked for cheap credits and companies rushed to close their funding gaps. At the end of 2010, the number of deals was twice as large as on average in 2006/07. The expansion came to an end in 2011, however. Some of that reflects the withdrawal of overseas issuers (from a deal share of about 15% in 2010 to near zero in 2012). Similarly big was the impact of the Euro debt crisis. The issuance volume from periphery countries dropped from EUR7.9 billion in 2010 to just EUR1.6 billion so far this year.

Monetary policy cannot fix the structural problems behind these problems in the financial sector. Nevertheless, monetary policy can ensure that the financial system does not collapse. Moreover, ultra-low interest rate and quantitative easing will push investors into riskier assets and, thus, help restore liquidity.

Disclaimer

This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 11 October 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

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