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Credit Sector Roundup
Last quarter we predicted that U.S. bank credit spreads would continue to be volatile, and the market certainly met our expectations. For example, the five-year credit spread for Citigroup (C, rating: A-) had a high of over 350 basis points and a low of 220 basis points for the quarter. Morgan Stanley (MS, rating: BBB) was even more volatile with its five-year credit spreads hitting a high of over 600 basis points and low of 300 basis points for the quarter.
The main source for all of this bank volatility is the possibility of a European financial crisis due to European sovereign debt problems. The market remains concerned that a European financial crisis could have serious direct and indirect effects on U.S. banks. European governments and the European Central Bank continue to attempt to address the primary issues, but to date they have not successfully achieved a comprehensive solution, which would include real enforcement measures and enable the European Union to require countries to follow a long-term plan. Even if they propose a comprehensive solution, we question whether or not European governments would have the populace support to implement such changes. We, therefore, continue to expect that bank credit spreads will remain volatile over the near term, and, for now, we believe this situation could remain for several quarters.
Even though U.S. bank credit spreads are volatile, the credit metrics for the banks continue to improve. Banks, and especially regional banks, are decreasing their percentage of nonperforming assets and increasing their core Tier 1 capital. We expect this trend to continue. Due to the flattening of the yield curve, however, we expect that bank net interest margins will continue to decline, damping overall returns and hurting the return on assets. As for European exposure, we continue to maintain that regional banks in the U.S. have very little, if any, exposure to Europe and that the large U.S. banks have manageable exposure. The overall situation in Europe, however, will still be the main catalyst for credit spread movement in the banking sector.
Basic materials bonds endured a wild ride in the fourth quarter, with day-to-day movements in spreads particularly exaggerated for industries levered to global industrial production and companies tied to European macroeconomic conditions. Despite what seem like weekly announcements by European politicians of critical "breakthroughs" in efforts to resolve the sovereign debt crisis, it's highly unlikely that the New Year will bring an end to the kind of whipsaw volatility in bond spreads that defined the fourth quarter.
From our perspective, the big swings have afforded opportunities to snap up solid investment-grade paper at spreads more indicative of high-yield land. One such name that periodically pops up on our radar has been ArcelorMittal (MT, Rating: BBB-), which we've been happy to add to our Best Ideas list when spreads have blown out to levels far exceeding our assessment of underlying credit risk.
Although we expect headlines out of Europe will continue to play a big role in basic materials bonds in the first quarter of 2012, we think macroeconomic conditions in the benighted continent are likely to share some of the unwanted spotlight with what has hitherto been the global economy's model student: China. Here, we've begun to see worrying signs, particularly as it pertains to the real estate market, where prices have begun to turn over and transaction volumes have dropped. Most commentators seem to expect Beijing to ride to the rescue, pulling multiple policy levers to relax the flow of credit (see, for example, the early December 50-basis-point cut to the reserve requirement ratio) and keep the situation from spiraling out of control.
Yet while policymakers in Beijing probably have more room to operate than their counterparts in Brussels or Washington, this isn't what we'd term an "easily managed" situation. After all, Beijing can increase the supply of credit all it wants, but it can do little in the near term to stimulate demand for credit. At the end of the day, the latter is really a story of sentiment. If homebuyers (many of whom are investors with no intention to occupy a purchased property) perceive that the real estate market is no longer the massively profitable one-way bet it has been for the past decade, things could spiral out of control pretty quickly, with potentially serious ramifications for the balance sheets of Chinese banks and local governments, both of which are significantly levered to the fortunes of the real estate market.