Credit Markets in 4D: Double-dip & debt-deflation?

- "To clarify one thing right at the start: neither a (global) double-dip recession nor a debtdeflation process is our base-case scenario. The most likely path is one of sluggish growth, a scenario that would be – at least in theory – preferable for credits. Nevertheless, there are plenty of signs that the tremendous recovery is coming to an end. Hence, with a slowdown of economic activity ahead, investors will ask themselves “where will the slowdown stop – above or below the zero line”? It is this discussion in a fragile environment that we are concerned about, as investors do not wait to discount an adverse scenario until it really unfolds. Moreover, developments over the last couple of years have shown that investors do not necessarily have to be the “follower” of economic developments, they can be the “leader”. An adverse economic development can be triggered by an erosion of confidence in financial markets. The problem is that – in particular in the European periphery – governments lack the financial flexibility to weather another storm. Investors should not forget that the major ingredients for a Great Depression-like scenario were “too much debt” and “deflation” – two factors that are also hanging like a Damocles Sword above us in the current scenario."
- Macro Outlook: "Reducing macroeconomic disequilibria in the eurozone implies the need for significant internal devaluation: Lessons from the Baltic countries, which are undergoing a similar problem, suggest huge challenges for the economies."
- Micro Fundamentals: "With government yields at record lows and piles of cash on corporate balance sheets, the question is whether a new M&A boom is imminent. We take a look at leverage of European corporate bond issuers to gain more insight."
- Debt-Equity-Linkage: "M&A activity and the loan market are two sides of the same coin. As M&A activity remains subdued so does loan origination."
- Credit Quality Trend: "The default rate forecast is driving spreads, but what is driving the forecast? Is it really highly sophisticated economic forecast models?"
- Market Technicals: "Loan origination volumes grew rapidly before the crisis and collapsed afterwards, partly due to the turmoil in the CLO market."
- Valuation & Timing: "Our fundamental concerns are more on a mid-term horizon. But on a short-term perspective, investors' focus on eurozone periphery sovereign debt, the 3Q earnings season and the outlook for 2011 could present catalysts for a more pronounced spread widening in the coming weeks."
- Other Credit Markets: Derivatives: "The rapid growth in credit derivatives over the last few years enlarged the spectrum of hedging possibilities also in EEMEA credits, albeit the market is still small and in most cases illiquid. Securitization: Update on European and US housing market. EEMEA Credits: Two-speed recovery also bears some deflationary risks."
- Allocation: "We leave our defensive credit portfolio allocation unchanged."
- Model Portfolio: "Our financials portfolio outperformed the benchmark by 9bp, while the non-financials portfolio outperformed by 6bp."

Unicredit Euro Credit Pilot Sep2010

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