From recession to depression

The week ended with the release of preliminary estimates on U.S. real GDP for the 4th quarter of 2008.

The "advance" estimate released on January 30th had already been heavily negative, with a decrease of 3.8% annualized, but today's review of the data - to be considered, therefore, more "accurate" even if not quite definitive - is truly daunting: from the 3rd to the 4th quarter the U.S. economy registered a contraction of 6.2% annualized, the worst result since 1982, due to all major components of real GDP, according to the statement released by the BEA (here), and especially to exports, personal consumption and residential investment.

The -6.2% in the last quarter of 2008 is a figure which shows much clearer than the -0.5% of the 3rd quarter that the current U.S. recession is increasingly shaping as really serious, and that it is entirely reasonable to ask if it's slipping towards the situation that analysts define as economic depression (technically, a decline in real GDP by over 10% compared to the previous peak).



Global Contraction

But the picture has become critical everywhere and the economic contraction may well be defined as synchronized on an international level.

Japan, the world second largest economy, recorded a -3.3% annualized in the last quarter of 2008 and I believe that the data of the Eurozone, equal to -1.5%, may still be revised downward, according to the most recent indicators, eg. the synthetic one reported in the following figure (the so-called €-coin index):



The ongoing global crisis is comparable, as size, to that of the early '80s. For 2009, estimates of total annual growth stood at around +0.5%, which implies a serious economic downturn in developed economies (in the U.S. and in the Eurozone the forecasts are for an annual GDP decrease of 2% approximately) and a very marked slowdown in the emerging countries. The year 2010 is expected by many as the year of recovery, although the indications so far are very few.

The basis of this negative view is the process, already in place, of a strong reduction of the leverage by households (particularly in the U.S. and UK), as well as by the major international financial institutions, which will still take considerable time to complete.

• the need for a strengthening of households wealth, placed at a severe test by the contraction of real estate and financial assets, as well by the risk - more and more concrete - of job lost, is causing an increase in the savings rate (even in the U.S. ) and then, a simultaneous decline in real consumption;
• the crisis in the banking system has enormous proportions, and, looking to history, it will take no less than 3 - 5 years before it can be consider passed (and, in this respect, the role of government and monetary authorities will be decisive), with heavy consequences on the mechanisms of credit and thus on overall economic growth.
  

2009 Forecast

For the current year, therefore, the expectation is for a significant increase in global output gap, for a decline in aggregate demand, for a general deterioration in the labor market, with peak unemployment of up to 9-10% in the U.S. The resulting reduction in the marginal cost of labor, combined with falling commodity prices, could fuel a deflationary phase, against which, however, the economic policy is working.

In this context, the financial markets could anticipate some time the achievement of the minimal point of the economic cycle, and undertake a first phase of stabilization, and then start to recover, but, in the short term, risk and volatility are certainly still very high.

The approach to investments at the moment can only remain extremely cautious and selective: it does not mean that one must stay completely out of equity and other risky assets, but I think it's not time still to weigh portfolios more than normal.


Original post: Da recessione a depressione

Why CCT are priced below par

I take the opportunity of a question from a reader to speak a little about CCT, namely the Italian State bonds at variable rates.

Some day ago I spoke with a colleague of mine who deals with finance for many decades (I have not written badly, just for decades!) and has got a lot of historical experience to: one with white hair, then, that told me he never had seen the prices of CCT, since they exist, so depressed, at levels well below the par, i.e. their nominal value (100), even when, in the early 90s, the old Italian lira came out from the EMS.

Why CCT have lost so much value in recent months? The problems are basically two:


1) more credit risk for Italy

The perception of credit risk relating to European countries called "peripheral", such as Italy, Greece, Ireland, Spain, Portugal, etc. is certainly worsened, and partly was reflected in real downgrade, as the one which caused Spain to lose the triple A.

For Italy, in particular, this has led to a sharp rise in spreads on contracts of Credit Default Swap (CDS) relating to debt securities issued by the Italian Republic, currently at 165, the worst figure among the G7 countries, as demonstrated by the following table (source: Markit).


Certainly the comparison among G7 may leave some doubt, if only you consider that, for example, the CDS on Japan is quoted about one quarter of the italian one, although the japanese government debt levels are, in my opinion, much more worrying than that - so much blamed - of Italy (in terms of debt / GDP ratio, for example, it is almost 200% against 105% of the domestic case).

The Italy risk, however, is well represented also by the asset swap spread of BTP, a value which, in a nutshell, measure the difference between the interest rate of the BTP (the fixed rate italian government bond) and the swap rate for the corresponding maturity: currently is about 90 bps on the ten years maturity.

Similar measure, finally, is the spread between the Italian BTP and German Bund, equivalent to approx. 170 bps on the same maturity, level higher than the previous one, both for rating differences (Germany is Triple A, while the swap curve underlies a rating of AA), and because the German securities have strongly benefited from the so called flight-to-quality.

Whatever the measure used, however, it is clear that the Italian government debt is under pressure, in this historic moment, for a worsening (at least perceived) of the relative credit risk.


2) the indexing to the BOT and not to the Euribor

There is another factor against the CCT, as always, but particularly in recent months: the Italian floater bond is indexed to the interest rate of the Italian BOT (typically at 6 months, with the addition of a spread of 15 bps), rather than to the Euribor which, as you know, represent the financial benchmark reference on short maturities.

Since the financial crisis has forced up the Euribor rates, i.e. roughly since the second half of 2007 and until a few weeks ago, the Euribor-BOT spread has been abnormally positive and thus unfavorable to underwriters of BOT and, indirectly, to those of CCT.

The situation has gradually improved recently, primarily for the rapid fall in Euribor, but the spread remains at very high levels, equivalent to more than 60 bp, and then to about 45 bp on rates of CCT.


CCT still suffering

Both factors (italian credit risk and spread Euribor-BOT) thus play against the CCT and both effects could determine "curious" effects as the one that was afraid by the reader above mentionned: if, for example, the european benchmark rates increased, but, at the same time, the credit spread of Italy and/or the spread Euribor-BOT worsen, the CCT would be penalized again.

My impression is that the prices of CCT are not intended to improve soon: however, for other aspects, this fact represents a potential opportunity, as the securities purchased at a discounted price today will be redeemed at maturity at their nominal value (assuming that there will be no default of our country) and that, in any event, this is index-linked bond that do not suffer much of a (possible) upward move of the yield curve in Europe.


Original post: Perché i CCT sono sotto la pari