Larry Hatheway and the UBS global asset allocation strategy research team see the US Government's plan to bail out Fannie and Freddie as a necessary but not sufficient condition for restoring investor confidence. Whilst any move to prevent a systemic crisis is a welcome one, the underlying deleveraging trend and its consequent adverse implications for both the financial sector and the real economy, remains intact. As such, they believe that the bounce in equities that we are seeing now, is likely to be short-lived.
Larry and team reiterate their medium-term asset-allocation strategy of being particularly overweight in investment-grade corporate bonds in the US, where they find valuation to be compelling ; and overweight in treasuries, where they believe that yields will continue to trend lower on the back of a weakening global economy ; against being particularly underweight in inflation-linked government bonds in the major markets ; and underweight in energy sector commodities.
Note that Laurie Goodman, the head of UBS' US MBS/ABS research team, is of the opinion that unless the US Government's plan somehow results in a loosening of underwriting standards in Fannie and Freddie that leads to a spurt in mortgage lending, there is no movement forward, but only the prevention of movement backwards, and just on one front. Also, if yields in the treasuries sector continues to rise, the benefit to the housing market from tighter spreads in the agency MBS sector will be offset in part, if not in full.
Meanwhile, overshadowed by this event was the August employment report in the US. Maury Harris and the UBS US economics research team sees these data as pointing to a continued slowdown in the American economy until early 2009, when a mild recovery then takes place. Note that they equally do not see any evidence of a severe recession, and stick by their weak-but-no-collapse scenario. They continue to forecast the Fed's policy rate being cut further to end this year at 1.50%, and the yield on the 10-year treasuries benchmark declining to 3.60%.
Also, Philip Finch and the UBS global banking sector equity research team reiterate their bearish stance on this sector. Whilst the worst of the impaired-asset write-downs is now behind us, the risk of fresh non-performing-loans is rising, as is the continued risk of liquidity dislocations. Moreover, with the deleveraging process only just started, profitability will remain under downward pressure. As such, they expect global bank stocks to trade back down in a range-bound mode, and continue to recommend Canadian banks, and selected emerging-market banks with strong retail deposit franchise and business model, whilst remaining adverse to American and Australian banks.
Also note that the "credit event" occurrence in credit-default-swaps on Fannie and Freddie is about to cause the dealer community a massive headache. Buyers of protection may actually suffer if there is a scramble for discount dollar-price deliverable obligations as Fannie and Freddie debt converges on to the treasuries curve, and start trading towards or above par.
Also, as these two names are quite common in synthetic CDO issues, where cash settlement is the norm, as opposed to physical settlement, coping with this event is going to be one big muddle! One interesting question is whether this event triggers any premature termination of the first-loss tranches of such synthetic CDO issues. Although the recovery rate from these two names is going to be high, the unwinding of delta and gamma hedges by dealers may create some inadvertent side-effects for the global credit markets. ISDA is organizing a conference-call with the dealer community at 11am New York tonight to try to sort out this process with minimum disruptions.
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