Credit Markets Not Panicked

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By Greg Peel

Suddenly the world is back focusing on Libor again, and not without reason. The London Interbank Offered Rate is the rate upon which all global credit is based in the commercial world, and it is the spread between 90-day Libor and a central bank's overnight cash rate which provides an indication of how willing banks are to lend to each other, which then translates to how willing banks are to on-lend to corporates.

A corporate's cost of funds determines its earnings capacity.

Like anything to do with money markets, it all gets a bit complicated. Strictly, the spread to watch is the Libor/OIS spread, where OIS means overnight indexed swaps being the rate at which a central bank will actually swap funds with a bank (the cash rate is the rate at which a central bank will withdraw or inject funds into the overnight banking system to control monetary policy).

Then when you translate the Libor rate across oceans, you end up with a localised version known as the dollar Libor rate in the US or the bank bill swap rate (BBSW) in Australia. Compare this to the local OIS, and you end up with a local risk spread for bank funds.

The world of course pays close attention to the US dollar Libor/OIS spread which has jumped dramatically since April on European debt fears, and Deutsche Bank notes spreads in the “dollar bloc” countries, which includes Australia, are also trending wider.

A widening of spreads is representative of a growing hesitancy from banks to lend to each other, unsure exactly what risk exposures their counterparties may be holding to Greece or any other teetering economies. It simply means they are charging higher interest rates to build in a greater risk premium.

In 2008 it was all about not knowing what exposures banks may be holding to toxic subprime CDOs, and Libor rates ticked up accordingly. The problem is that uncertainty begets fear which begets panic, such that when Lehman collapsed the Libor rate jumped signifcantly. Now that Libor is on the move again, markets are thinking back to 2008 and recalling the words of Jeff Goldblum in Jurassic Park II – “That's when the screaming starts”.

Pacifica Partners Capital Management is clearly somewhat concerned about Libor if the following graph, and graphic, is anything to go by.

Note the two significant up moves in September 2008 and the first three months of 2009. The big drop in the middle was the period when central banks madly slashed their cash rates down to, in America's case, nothing. So adjusting for cash rate movements means Libor increases were reflecting heightened fear from September 2008 through to March 2009 when stock markets bottomed.

Note also that this is a log-scaled graph, so realistically what looks like a big jump in May 2010 is absolutely nothing like the move in September 2008.

And this is what many analysts and economists are emphasising at this point. So far, the reaction of global credit markets to the European debt crisis pails into insignificance compared to the original GFC.

But if you're a stock market player, you'd be reliving the nightmare of 2008, so violent has been the correction to date. However I made the point previously in The Fear Of Fear Itself that if it wasn't for 2008 being so fresh a painful memory, the European crisis in isolation would probably not have evoked quite so panicked a response.

Deutsche Bank's global fixed income analysts view the current credit market environment as such:

“We think that the period ahead will continue to see volatility in the [credit] spreads, and some further outward pressure [widening], but we expect that it will be significantly better contained than in previous episodes, partly as a result of the proactive measures already taken by central banks in the past few weeks, as well as the strong precedents of liquidity support seen over the past two years. Nevertheless we will continue monitoring developments in the market closely.”

RBS Australia's equity analysts are on the same page, noting:

“Since the start of May the S&P/ASX 200 has corrected by 11%, yet spreads in debt markets, while elevated, are nowhere near the levels seen in the GFC.”

RBS does not believe there will be a debt default in Europe, albeit austerity measures will lead to curbed demand and slower economic growth. Australia's exposure to Europe in terms of the broader economy is limited given our direct trade links are less than 4% or about half a GDP percentage point, the analysts calculate. There is nevertheless an indirect exposure via China's greater trade links with Europe.

But RBS believes many Australian stocks have now overshot to the downside and are thus offering “considerable” upside. Not surprisingly, the addition of RSPT confusion mean that miners dominate a list of stocks for which RBS has Buy recommendations, which have fallen more than 10% and which offer 30% or more return on a move to the analysts' target prices.

BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals are included in the list, and beyond iron ore RBS highlights Origin Energy ((ORG)), Toll Holdings ((TOL)) and MAp Group ((MAP)).

For more on iron ore and the RSPT see today's Material Matters.

Credit Suisse also sees opportunities in the Australian oil and gas sector, given the big general sell-down has wiped off “layers of risk” from LNG development and exploration program valuations. The analysts believe the RSPT is “a bit of a non-event” for the energy sector given the sector has been offered a choice of paying the RSPT or the already existing Petroleum Resource Rent Tax but not both. Start-up CSM-LNG projects would be most affected, notes CS, but not to the extent of prompting project cancellations in the analysts' opinion.

To that end, Credit Suisse is most keen on Woodside Petroleum ((WPL)) and Oil Search ((OSH)). Santos ((STO)) needs to prove it can take the next step in order to outperform, while Eastern Star Gas ((ESG)) is the broker's preferred CSM development play for the longer term. For those CSM-LNG companies further down the track, CS suggests the market will be waiting until later in the year to “buy the fact” on anticipated positive announcements.

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