The Squeeze On Equities

Credit markets are forecasting further pain for equity investors.

In Michael Lewis’s entertaining recent article on “The End of Wall Street’s Boom” he quotes hedge fund manager Steve Eisman as saying, “What most people don’t realise is that the fixed income world dwarfs the equity world … the equity world is like a ******* zit compared with the bond market.”

In fact it’s taken many equity investors a large part of 2008 to understand that what’s going on in the credit markets, and specifically in the credit-default swap (CDS) market, is currently the key determinant for share prices. I met last Friday with CMA Datavision, who specialise in providing CDS quotes and information to market participants. They told me that a year ago only specialist credit fund managers, typically from the hedge fund community, were interested in what they were tracking. In the last few months, they said, the level of interest from elsewhere has shot up. They now have all manner of equity fund managers, consultants, central bankers and journalists like me pestering them for information.

And quite rightly so. Whatever you think of the CDS market (there are still plenty of people who want it shut down in its current form, due to the systemic risk resulting from lots of opaque, and uncollateralised or unmargined contracts between the participants), it is telling us a lot of useful information about the health (or otherwise) of corporations and governments. If your equity investment’s five-year CDS spread goes to 1000 basis points, for example, then the market is telling you that there is a significant probability of default during the period. And if the company you own equity in defaults on its debt, good luck arguing that your shares are worth anything more than zero.

Unfortunately for equity investors, CDS spreads across the world continue to climb, as the credit freeze becomes ever more intense. A revealing article in yesterday’s Financial Times spelled out just how much more even the better corporates are paying to refinance their debts – National Grid in the UK paying 7 times more, and Daimler 20 times more in terms of credit spread than before the crunch. Meanwhile the iTraxx crossover index of “junkier” credits today hit new highs, approaching the 1000 basis points mark. And, not to be left out, the CDS spreads on the sovereign debt of the UK, US, Italy, France, Spain and Germany all hit new highs as well.

We’ve seen a number of periods in the last year when equities have rallied, anticipating the end of the downturn, while credit conditions have continued to deteriorate.  After last week’s rise in share prices, is this another such episode, doomed to end in disappointment for equity bulls?

And with all this in mind it’s also slightly surprising that the European ETFs that track the credit markets have more money invested in the long versions (which benefit if credit spreads fall) than in the short versions (which benefit when spreads rise, as they have been doing all year – EasyETF and db x-trackers both offer credit ETFs tracking different iTraxx credit indices, with only db x-trackers offering inverse versions of each).

For example, db x-trackers has €152 million invested in its iTraxx Crossover 5 Year Total Return ETF (which is down 14% year-to-date), and only €18 million in the inverse version, its iTraxx Crossover 5 Year Short Total Return ETF (which is up 21% year to date).

Contrast this with the long/short ETFs tracking various European equity indices, where the short ETFs have often had more money invested than the long versions at times this year.

So as investor awareness of the importance of the credit markets increases, it seems a safe bet that assets devoted to this sector of the ETF market will grow.  And, to paraphrase Steve Eisman, equity investors are not doing their job if they ignore the credit “elephant in the room”.

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