Financials to be slow to repair in 2009 with tight credit condition

The issues currently plaguing the system will not wash away come January. And in the face of "historically extreme stimulus", investors will continue to face an ever-deteriorating macroeconomic backdrop, with continued downside risk, a Morgan Stanley report said.

In its 2009 Outlook: Global Credit Strategy report, the New York-based investment bank said that while the world is entering a very challenging year, credit valuations are also at unprecedented levels and imply an "economic Armageddon".

Calling 2009 as "the year of credit", Morgan Stanley said credit is the preferred asset class in the year ahead.

"In a world fraught with deflationary pressures and lower projected returns, a strong case can be made to own credit on not only a relative basis, but also an absolute one," the report, sent to Emirates Business said.

"Our equity strategists have a base case return of 10 per cent for the US and three per cent in Europe, with bear case estimates of down 54 per cent and 33 per cent, respectively. In that context, using draconian assumptions our forecast unlevered returns for IG cash of about 7.5 per cent and about 17 per cent for high yield bonds seem quite comparable. And since credit investments at these discounted prices have considerably more downside protection, we find the asset class to be an attractive alternative to equities in 2009," it said. In a bigger picture however, Morgan Stanley said in all of its scenarios, one thing is apparent: the world is in a synchronised recession. With a "fragile" global economy, Morgan Stanley's 2009 base case estimate for global real GDP is 0.9 per cent with a bear case of minus 0.8 per cent and a bull case of 2.3 per cent.

The US base case growth is forecast at minus 1.9 per cent with a minus 2.9 per cent bear case and minus 1.2 per cent bull case and the risks remain to the downside.

It said the inability to properly calibrate the effect of the breakdown in the securitization markets on the financial system and thus the economy remain a continued threat to gaining comfort on predicting a bottom.

"In addition, we see continued fragility and stress in the financial world, which in turn will prompt tight credit conditions," the report said.

But it added that financials are also on the steady, slow road to repair. Yet until asset prices stabilise and profits rebuild (and thus capital bases), a tight credit environment is still to ensue.

"Tight credit conditions are important for many reasons, not least of which is the feedback loop to corporate profits," it said.

Sequencing the steps necessary to heal credit fundamentals and market technicals is the single most important challenge for credit investors during 2009, it said adding that four broad components to the sequencing process need to take place in order to stabilise credit markets over the course of 2009. These components are systemic repair, bank deleveraging; progress in the corporate earnings cycle and housing market stabilisation.

SYSTEMIC REPAIR

Systemic healing is a prerequisite before making any further progress towards the end of this bear market.

If large financial intermediaries cannot deal with one another without the fear of counterparty failure, financial markets cannot operate, assets become illiquid, and a deleveraging fire sale leading to a depression is the inevitable endgame.

"The Lehman default represented a culmination in the breakdown of the counterparty risk system that had been gathering pace steadily since the early part of 2007.

"Although Lehman represented the functional equivalent of cardiac arrest for the global financial system, it also galvanised an official response that had been largely lacking until that point. It was this response that kick-started the first stage in the healing sequence – systemic repair," it said.

DELEVERAGING

After the systemic repair, deleveraging should come next. Deleveraging both starts and finishes with the banks, it said. If capital raises are not in the offing in 2009, then further asset contraction will need to occur to bring leverage down to mid-teen levels of the late 1990s.

European banks, on the other hand, have made slower process on deleveraging, it said, with several relying on the use of non-mark to market accounting as opposed to writedowns and outright asset sales.

"We believe this approach will be undermined by higher realised credit losses during 2009 that will prolong the deleveraging process," it said.

"While the bulk of 2008 was a story of systemic risk and financial market deleveraging, we believe 2009 will witness a shift towards fundamentally driven dispersion trades – a trend that already got started in 2008 fourth quarter but has further to go. The position of bank creditors will be underpinned by explicit sovereign support, although this raises concerns over sovereign funding that we believe may surface during 2009."

SURVIVING THE CORPORATE PROFIT DOWNDRAFT

While the outlook for systemic healing recently turned the corner, the downturn for non-financial corporate profits is only just starting.

This, according to Morgan Stanley, is the primary downside risk for next year. Non-financial corporate profit margins remain far above the long-term trend, and this is very likely to mean-revert and overshoot on the downside during 2009.

CYCLICALS UNDERPERFORMED MATERIALLY

"We think this process has further to go in the early part of next year. This also implies a steady closing of the gap between default rates and high yield credit spreads over the course of the next year, with a peak for default rates not likely before 2010," Morgan Stanley report said.

HOUSING MARKET STABILISATION

In contrast to Abn Amro Private Banking's forecast that the US will be the first to go out as it is the first to go in, Morgan Stanley said although US housing was the catalyst that started this crisis it may be one of the last areas to hit a final trough.

"Although house prices (along with foreclosure rates) will be the single biggest determinant of the final losses on residential mortgage backed securities, we suspect that broader corporate bond and equity markets will trough before house prices reach their final nadir," It said.

It noted that its outlook for US home prices is quite dire with a peak to trough decline forecast of 40 per cent.

US recession goes deep and wide

The US recession will be the deepest, but the dispersion of risks is widest in emerging markets (EM) economies, Morgan Stanley said.

"They (EM) are more highly leveraged to global growth, and inflation risks remain a policy challenge," it said. "Laggard policy responses imply downside risks to growth in EM as well as Europe and Japan."

It said the UAE risks to near-term outlook are driven by the oil markets, the domestic real estate sector and the availability of foreign financing.

Although both fiscal and external accounts are expected to remain balanced at oil prices of about $40 per barrel, continued weakness in oil markets may lead to further output cuts, an adverse effect on oil sector growth, more moderate growth in public investments, and lower exports of services to neighbouring oil-producing countries.

The outlook on the other hand for the US, the Euro area and the UK is mundane. In the US, its baseline outlook assumes that home prices would decline by another 10 per cent for a peak-to-trough total of 18 per cent. In the Euro area, its bear case – which is 30 per cent subjective probability – incorporates a domestic demand crunch caused by several factors. First, a noticeable reduction in the availability of credit to the non-financial private sector, rather than our baseline assumption of a gradual tightening in credit conditions and credit availability in line with a typical recession.

Second, instead of easing slightly as in our baseline, the household saving rate could start to rise noticeably. Third, faced with a sharp deterioration in budget dynamics, governments might find it more expensive to fund themselves and private investment projects could be crowded out. Fourth, effective funding costs might go up considerably.

Overall, Morgan Stanley has sharply cut its outlook for global growth and inflation in 2009 for the sixth time in seven months, this time to 0.9 per cent and 2.6 per cent, respectively, from 1.7 per cent and 3.8 per cent in November.

Despite unprecedented global policy stimulus, it said the 2010 recovery is likely to be moderate.

"Our baseline view takes growth back up to 3.3 per cent in 2010, with inflation at 3.7 per cent. If that outlook is realised, global growth in 2009-10 would be the second weakest in the post-war period, barely stronger than in the deep 1982-83 downturn," it added.

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