Credit markets deliver a warning

PORTFOLIO POINT: A worrying signal has emerged that the international credit market’s view of Australian banks is extremely negative.

In our last commentary on the state of financial markets (click here), the earnings fundamentals were coming through strongly in the US, an early handshake agreement on the debt ceiling had been announced and political will around a European solution appeared to be in evidence in mid-July, giving us some confidence following recent falls in the market.

The following week credit markets began to exhibit extreme signs of volatility that developed into a full-scale rout on equity markets, fanned by politicians on both sides of the Atlantic. Warning signals in credit markets often presage coming corrections in the equity markets and are worth watching closely.

In this instance we used these warning signals as an opportunity to move away from equities into US Treasury bonds, UK gilts, emerging market sovereign bonds and gold, and were subsequently rewarded. Although many of the signs I noted in July are still evident, it is telling that the ASX 200 is virtually flat for the month of August, notwithstanding today’s selloff.

While there have been good valuations to take advantage of in panic situations for the long term; the credit market’s continued instability points to more equity market instability on the horizon and problems that the market was worried about still haven’t been fixed.

In particular, there has been a lack of proactive leadership in Europe to fix the sovereign debt problem and it will take a large market reaction to force action; which may well be on its way. I believe there be will further opportunities in the coming months, and patient investors should keep their powder dry because large market dislocations like this are rarely solved quickly and lightening up exposure here makes prudent sense.

If you do want to be exposed to equities, I would suggest reallocating in a defensive manner away from resources and banks and towards utilities and consumer non-cyclicals; which this month in Australia have been significant outperformers. We expect that to continue.

You can see this in the chart below. The blue line is the Australian Resources Index/Australian Consumer Non-Cyclicals index; when it trends downwards as it has been, defensives are outperforming resources, which we expect to continue. The bottom section of the chart shows the ASX 200.

A shock to the markets like the one we have experienced, both to consumer /investor confidence and to the technicals in the market, rarely in my experience results in a return to normality in a week; more like several months to rebuild confidence and belief in the fundamentals.

Right now we believe the fundamentals in the market are meaningless to make investment decisions, as fear and greed and expectations of the future take hold, causing wide seemingly irrational swings in the markets. It will be some time until the fundamentals can be relied on again as accurate pointers to market performance. It is in these periods of market dislocation that both great opportunities and great risks abound. Often for retail investors it is better to be prudent and defensive and wait for definitive signals that confidence has returned before adding more exposure to the equities market.

As you can see below, some of the factors we focus on in the credit markets as red flags, in addition to some of our proprietary screens; are the Euribor OIS spread which shows the willingness of banks to lend for three months versus overnight.

Elevated levels in this spread shows an increasing reluctance for European banks to lend to each other and usually are the prelude to equity market instability as liquidity dries up and balance sheet hoarding occurs.

As you can see we are at elevated levels and until we see a large reduction, generally back through its 15 week moving average, we will remain extremely cautious. The green line is the bank-heavy Eurostoxx 50 index.

Looking closer to home, a most worrying signal has emerged from the Australian market for banking credit default swaps. Credit default swaps are the cost of insuring bonds against a default and are now trading at crisis levels, indicating the international credit market’s view of Australian banks is extremely negative.

The chart below contains a comparison of the five-year subordinated credit default swap of Westpac versus that of UOB, which is a top-tier Singapore bank but with a lower credit rating.

Given the reliance of Australian banks on international financing, this indicates a supreme lack of confidence in the affairs of our banks, and yet until today the share prices of our banks have largely been flat (for more on how to protect your bank shares, click here).

Something is most definitely amiss here and Australian investors appear to have been substantially mispricing the risk. We will find out by how much in coming weeks.

As for our fund, we will stay in bonds and gold for the interim and wait for the next rotation towards risk. This will manifest itself in the coming months in emerging market equities where the largest gains are typically to be made from a return to market confidence; typically in markets such as South Korea, Taiwan, Russia, India, Brazil and Indonesia, which can all be accessed using exchange traded funds on the NYSE and, to a lesser extent, the ASX.

Andrew Switajewski is the chief investment officer of Swita Investment Management. He may have interests in any of the securities mentioned.

The advice provided in this article is general in nature is not advice or a recommendation to buy or sell and it does not take into account your needs, objectives or financial situation. You should always take these matters into consideration before making an investment decision and consult an adviser before investing.