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Credit Wrap
August 1 2008, Markit Credit Wrap - The Week in Perspective
It is beyond dispute that the financial system has been the catalyst for the current correction. An easy money environment, along with flaws in risk management and regulation, magnified the effects of the US housing bubble implosion. Recent weeks, however, have seen a change in sentiment, with investors hopeful that banks have turned a corner. First, there was the better than expected results from a plethora of venerable financial institutions. Then this week Merrill Lynch announced that it was disposing of a large CDO portfolio at a significant loss. On the face of it, this doesn't appear to be good news. But investors welcomed Merrill's commitment to disclosure and its willingness to accept its losses - a characteristic perhaps in short supply across the sector. Hopes that other banks will follow suit caused financials to outperform compared to the broader market this week. An extension of liquidity facilities provided by the Federal Reserve also helped sentiment.
But the travails of the financials sector have not been self-contained, a fact all too obvious from economic releases in the latter part of this week. US GDP figures for the second-quarter came in at annualised rate of 1.9%, an improvement from the previous quarter but below expectations. New figures showing a contraction in 2007 fourth-quarter GDP raised the prospect of a technical recession. The performance of the labour market - usually a lagging indicator of the economy - has continued to worsen. Although today's non-farm payrolls report showed a smaller than expected loss of jobs, the unemployment rate rose to a 5.7%, its highest level in four years. Unsurprisingly, manufacturing and construction bore the brunt of the losses.
The outlook for these sectors looks bleak, and not just in the US. Today's UK manufacturing PMI report, produced by CIPS/Markit Economics, shows that producers are growing even more pessimistic about orders. However, the report also showed that more and more companies are expecting to increase prices. The PMI is a leading indicator of the economy and regarded as one of the best predictors of output. Today's reading encapsulates the awkward position the Bank of England is in, with risks to growth on the downside and inflationary pressures rising, and will cement expectations that rates will stay on hold in the near future.
Clearly, the financial sector cannot take all of the blame for the economic downturn, contrary to some of the shriller elements of the mainstream press. The sharp rise in commodity prices has had a significant effect on consumer confidence and damaged corporate margins. The inflation it has generated has left monetary authorities with limited means to boost growth. If financials have indeed turned a corner - and systemic risk has undoubtedly diminished since the beginning of the year - then the focus will return to sectors traditionally hurt in a slump.