Louise Purtle

opinion

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Dollar doldrums

Nobody likes to begin the New Year with a hangover. But for all that we like to believe you can wipe the slate clean on January 1, the truth, at least for the markets, is that the themes of the previous year persist. The stress points that are currently evident are likely to continue exerting their effects in 2005.

Foremost among those stress points is the imbalance in the global economy that is finding expression in the US dollar’s depreciation. While corporate bond investors can look favourably on the increased competitiveness in global markets afforded US firms by the currency’s fall, many aspects of the trend give more cause for concern. Washington’s seeming willingness to embrace a lower dollar means foreign investors are facing probable erosion of the value of their substantial dollar-denominated holdings.

A fall in demand for dollar-based assets from non-US investors or, more worryingly, a potential repatriation of investments, could require an interest rate response that sees a structural shift higher in US yields. Already, the Fed is indicating greater inflationary concern and this would only be made worse by further depreciation. This raises the potential for US rates in 2005 to be higher than might be considered optimal given the level of domestic demand. So global credit investors have reason to be concerned that spreads could be pressured wider in a general US interest rate move. They also have reason to be concerned that rate increases could undermine US consumer confidence.

With margins already squeezed by rising input costs, companies are particularly sensitive to their inability to gain pricing traction. The data on this of late has been somewhat contradictory, with central banks citing evidence of rising prices as one reason they need to be more vigilant on inflation – but companies are meeting with resistance to any cessation of discounting. In certain sectors, such as the car industry, the lack of pricing power is clearly evident, with the major car manufacturers relaunching aggressive incentive programmes in December to help clear their inventory backlog.

The risk that operating conditions could become far more challenging is exacerbated by the historically tight level of pricing that currently prevails in the credit markets. While investment-grade spreads have tightened modestly over the course of 2004, the speculative-grade arena saw a late rally that took spreads to levels that are, to say the least, extremely optimistic.

If spreads were being priced off fundamentals and had not been impacted by continued tight technical conditions and the ongoing grab for yield, they would probably already be trending wider. Those technical conditions will not quickly dissipate, as they partially reflect secular trends that are causing an overall shift lower in credit quality. But this means that investors are paying more for a lower degree of asset coverage and a reduced debt-servicing ability at a time when the corporate profitability cycle appears to have already turned and the outlook is more negative.

The risk/reward trade-off of remaining invested in credit and continuing to pursue the high-beta compression trade is increasing. As global growth and demand forecasts for the coming year are scaled down and inflation forecasts are increased, credit investors should expect a consequent response in the pricing of credit, particularly in the more exposed, lower-rated names that they have so willingly invested in during 2004. It may not be such a happy New Year. n

Louise Purtle is corporate stategist at independent research provider CreditSights

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