Mike Materasso is senior vice-president and co-chair of the fixed-income policy committee at Franklin Templeton in New York. The firm was named best fixed-income manager for AsianInvestor's 2009 Investment Performance Awards.
What do you make of the retracement of credit spreads?
Materasso: Spreads on many sectors are back to where they were right after the collapse of Lehman Brothers in late September 2008. This may form a sort of risk benchmark. It seems now the US economy and its capital markets are on a sounder footing than in September, although perhaps some of the technical support for credit markets is getting ahead of the fundamentals. But if you're waiting for a signal that the economy has either tanked or is recovering, you've missed the market.
How do you judge US government policy moves?
From the bailout of Fannie Mae and Freddie Mac in September through Thanksgiving [late November], government policy was ad hoc. Policymakers faced multiple events and it was impossible to deal with these in a consistent way. In hindsight, had there been in place a regime for restructuring financial institutions, maybe we wouldn't have to have put Fannie and Freddie into conservatorship. Maybe the Lehman and AIG collapses would have been handled better. But these events did force policymakers to be aware of the severity of the crisis, and the need for funding.
Today we have a new administration. The Fed has enacted a policy of quantitative easing. It has added new facilities such as expanding its balance sheet to purchase mortgage securities. We have Tarp, Talf and P-Pip. I don't think you can point to any one policy, but collectively, this response has credibility in creating liquidity, lowering borrowing costs and improving confidence in our markets. Now we have to hope that these fiscal and monetary stimulus packages will heal the broken parts of our economy.
What's the outlook for the economy?
The US economy should recover late '09, early 2010 but will probably grow below potential for some time. Financial institutions are deleveraging and consolidating resulting in further job losses. Consumer spending should be subdued due to job insecurity, limited avenues of borrowing and rebuilding of savings for education and retirement. The silver lining to all these headwinds is that it will give the Fed a little more leeway when it comes time to take away some of its stimulus.
What's the opportunity look like in credit?
The average spread on high yield is almost 1,200 basis points over Treasuries, versus a long-term average spread of 550bps. Eventually there's room for these spreads to tighten. High grade credit spreads are now 400bps, versus the wides of 240-250bps that we've seen during previous recessions. In the first quarter of 2009, both of these asset classes beat equities and provided investors a better place in the capital structure. High yield in particular returned almost 19% year to date. High yield may correct a bit given the large gap between the current default rate and the projected peak in defaults.
Spreads have tightened over March and April -- where does that leave us?
The past two months of April and May have been eerily similar to April and May 2008, right after the collapse of Bear Stearns. Markets began to recover. There was a sense that the economy was stabilising. The first sector to recover was commercial MBS. Banks were raising tier-1 capital.
So are we in for another rude shock?
Well, the difference this time is that US monetary and fiscal policies are credible.
What are the risks?
One is that a lot of securities have been bought in anticipation of the Treasury's Public/Private Investment Partnership [P-Pip] program. But what if they've overestimated investor demand?
What are the question marks regarding the Fed's ability to prevent inflation?
What metrics will the Fed use to decide when and how to put on the brakes. Of course this is a worry, but many of the Fed's programs are meant to be unwound as the markets come back. The Fed's balance sheet has actually shrunk in some areas where it's ceased activity, such as the issuance of commercial paper. This reflects the fact that the market doesn't need the Fed's assistance anymore. Ultimately the decision about the Fed's taking away the punch bowl may not be in its hands. Remember, there's a cost to borrowing from the Fed.
So what is the Fed going to do with all of those Treasuries and mortgage-backed securities it is buying?
Some will mature and go away naturally. But not all of them will. There's a potential overhang in the market, especially if the Fed needs to sell these securities in order to help the Treasury fund a growing budget deficit. The market had similar concerns about Japan, when the BoJ bought up Treasuries in the 1980s. The BoJ did in fact end up selling its Treasury holdings, at a time of falling interest rates. The impact was marginal. But the US situation is a lot bigger. However this problem is not going to emerge for three years. It's still a way off.