This ratio has been smoothed to help identify the emerging trend, which has been upward since the latter part of February. Since mid-March, i.e., from the time of the collapse and rescue operation of Bear Stearns, the spread on high yielding corporate debt has narrowed by nearly 150 basis points.
These trends could turn back easily on themselves and need watching but the interesting point is that the downgrading of consensus earnings estimates has lost momentum. What is coming out of the US quarterly reporting round at its half way stage is that earnings for the non-financial corporate sector of the S&P 500 are surprising on the upside, in part due to the ‘international earners’ which are benefiting from the dollar’s competitive position as well as from a slowing but still growing global economy.
It remains to be seen how beneficial the central banks initiatives intended to help unblock the lending channels that facilitate growth prove to be. While the strains may linger in the interbank markets, the degree of apprehension associated with the credit crisis has lessened. Market volatility has diminished; the flight to quality has been shunned - yields at the short end of the US Treasury market have edged up above the Federal Funds rate - and high yield spreads have continued narrowing. Equity markets are off their lows for this year.
Given this backdrop, resistance to further aggressive cuts in US interest rates is not only likely but the case for putting Fed policy on hold, at least temporarily, could be building in view of the concern, within the FOMC, that inflation expectations are becoming less well anchored. We think that the FOMC will be disposed to holding the line on interest rates when it meets next week. It may choose to ease its way into this position by granting the quarter point cut in the Federal Funds rate that the markets have been expecting, but it may just decide that, having done so much already, enough is enough for a while.
By our reckoning, the real oil price (chart below) has now climbed to within reach of the record levels last seen in the late 1970s, when the second oil tremors shook the world. High real oil prices may not be inflicting the damage they did back then but they are constraining demand via the influence of headline inflation on real disposable incomes. They are also pushing up costs for the corporate sector so profitability is getting squeezed from all sides and to that extent high real oil prices represent a downside risk for equity markets.
However, if the credit markets have priced in a short and shallow US recession and are discounting the worst of it, it is likely that equity markets are doing the same. And if the momentum underlying the downgrading of corporate earnings is in the process of turning and the non-financial corporate sector is surprising on the upside with its earnings (as noted in Earnings Surprises – What Scope for a Shock? 18 April 2008), valuations become a bit more appealing and equity markets a bit more tempting.
