Credit - Market commentary and Financial views

Credit
Market commentary
What a setback! In contrast to expectations, it took only a few minutes for investors to
digest and ignore the announcement on Monday of the EU/IMF bail-out of Ireland before
jittery markets took PIIGS spreads soaring again. In beautifully rounded numbers,
currently Italy trades around 200bp, Spain 300bp, Portugal close to 500bp, Ireland close
to a record-high 600bp and Greece around 1000bp.

Now the big question is whether market participants will find the new Irish austerity
measures credible taking into consideration the fear surrounding the distressed banking
sector. More dramatic measures in this respect are likely to be announced in the coming
days. In context, S&P downgraded the sovereign rating of Ireland on Tuesday by two
notches to A with Negative Watch due to the troubled banking system and the need for
further capital injections and supply of liquidity.

Focus is now on the next peripheral in line – Portugal. Even if the current pressure on
Portugal were to lead to unsustainable levels, we believe the EU would be able to cope
with this. A stronger test for the eurozone would arise should Spain (due to the size of the
economy) be the next PIIGS country to fall victim to heavy market turbulence, which we
think is likely. Consequently, we believe the ECB needs to reconsider its exit strategy
from emergency measures, especially the withdrawal of bank liquidity support. The next
ECB decision on the matter will be on 2 December. Currently, the ECB provides
unlimited liquidity for one week, one month and three months at a fixed rate of 1%.

As mentioned above, sovereign peripheral spreads continued to drift wider during the
week with contagion to the broader CDS markets. The iTraxx Main and Crossover
currently trade around 107bp and 483bp, which is 7bp and 28bp wider than Friday,
respectively. As usual when sovereign concerns resurface, iTraxx Senior Financials
underperforms and is 23bp wider at 159bp. An even more evident underperformance has
been seen in the Sub Financials index which has increased 43bp since last Friday to
269bp. Today the multiple between the sub and senior index is 1.69x – up from 1.44x just
one month ago.

The primary market
Primary issuance in corporate bonds has been rather subdued during the week with a
SEK1.5bn tap from Stora Enso and 8Y fixed maturities from ENI and Credit Mutuel as
the most interesting.


Financial views
Equities
• In our view, focus, which has been on the Q3 earnings season and the crisis in
Europe, should now shift back to macro and we should see signs of sustainability in
the global economy. Company profits have been living separately from the rest of the
economy but in order to continue with a strong profit cycle in 2011, support is needed
from a recovery in the OECD job and consumption cycle and a renewed pick-up in
the global industry cycle. This is clear from the non-event in top-line surprises seen in
the Q3 earnings season. With companies being squeezed by rising input costs and
falling sales prices, top-line growth is the one way to keep up the profit cycle. We
reiterate our recommendation to overweight financials and maintain our defensive
stance on cyclicals though moving a little bit towards balance between the two. We
continue to look for softness in the global stock markets.

Fixed income
• The post-QE2 sell-off in US Treasuries is overdone. Going into year-end we look for
lower long bond yields in the US and Germany, partly helped by the increasing
turmoil in PIIGS. The big picture, however, is that bond yields are now forming a
trough. We forecast rising yields throughout 2011 as economic growth reaccelerates
and core inflation bottoms out. During 2011 German bonds are expected to
underperform the US, as the ECB moves on with normalisation and eventually
tightening, while the Fed will remain in easing mode for a while longer.
• Intra-Euroland and Scandi: We are long Germany and Italy versus Spain and France.
We also recommend buying T-bills issued from Italy, Ireland, Greece, Portugal and
Spain. We are overweight Scandinavia versus Euroland.

Credit
• We remain slightly positive on especially corporate credit issuers for the moment, but
the asset class is becoming mainly a carry play as recent spread tightening reduces
upside. Companies are still acting conservatively although event risk is on the rise as
companies embark on more shareholder-friendly actions. Furthermore, renewed tension
due to the sovereign debt crisis is weighing on banks at both senior and sub levels.
• Primary market activity is levelling off but we still expect some activity before we
close off for the year in December.

FX outlook
• European debt woes continue to weigh on EUR and positioning is still not posing a
limit to a further sell-off. Until a turnaround in sentiment towards the eurozone
peripheral is triggered – which will probably require a new strong policy response –
EUR/USD is likely to drift lower; a potential test of 1.30 cannot be ruled out.
However, economic data is improving and global risk sentiment remains fairly
immune, implying that: (i) USD/JPY support is likely to remain, and (ii) should the
euro credit premium ease, the financial environment would provide strong support.
• The Scandies are not trading as fiscal safe havens; rather, both SEK and NOK
continue to trade closely with global risk sentiment. As long as risky assets can trade
separately from the eurozone peripherals – as we have seen in recent days – both
EUR/SEK and EUR/NOK should move lower. Hence, we still see good value in the
Scandies, and even as short-term risks remain, these are (for now) slowly fading.


Commodities
• Oil has once again found strong support towards the lower end of the USD80-90/bbl
range and we emphasise that there have in fact been improvements in fundamentals to
potentially sustain current price levels. Near-term price setbacks in commodity prices
are still likely though as equities and the euro could take some hits.
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