Letter from New York

Stefan and I had a research trip to see our New York counterparties at the end of last week. Two key themes emerged. Firstly, when we were there a year ago, many of the Wall Street strategists were cautious on high yield and investment grade bonds. But after a year of strong returns from credit – and especially risky credit – capitulation appears to be the order of the day. Not one strategist was anything but positive on the asset class. There are a couple of reasons why – the high yield default rate continues to stay around 1%, and the demand for corporate bonds from structured credit vehicles like CDOs (and CPDOs, see our earlier post) remains incredibly high. This strikes me as a little complacent, after all since I was last in NY the US growth rate has collapsed. GDP growth was over 5% in the first quarter of 2006, but is likely to be running at around a 2% rate in Q4 – and according to some indicators like the ISM manufacturing survey, the industrial sector may well be approaching recession. This can’t be good for credit fundamentals, and we continue to think that it’s time to rotate out of riskier corporate bonds into more conservative issuers.

Secondly, the Wall Street economists on the whole think that 2007 will see a continued US slowdown rather than a recession. A couple of people we saw even thought that US rates would end the year at their current level (5.25%) or higher. There were a couple of outliers however. Both Merrill Lynch’s David Rosenberg and BNP’s Richard Iley see the US housing market weakness tipping US growth over a cliff next year. The US corporate savings rate is currently extremely high (companies are very cash rich and can’t find opportunities to invest in the US, which in itself is quite bearish – has the US economy gone “ex-growth”?) – what happens if the US consumer weakens further and starts to save rather than spend? As a result Rosenberg sees the Fed cutting to 3.75% by year end, and Iley to an even more punchy 3% – both moves implying that the US is getting a hard landing rather than the consensus soft landing.