Credit markets outperformed during the month of July, but already the environment feels so changed as for investors to believe that there is little that can be extrapolated from the result into the remainder of the year. The Merrill Lynch U.S. Corporate Master index returned 1.21% for the month and delivered excess return of 0.16% versus the Treasury market as aggregate spreads managed to tighten by 3 basis points, ending July at 94bps on the back of a strong second-quarter earnings season. Further down the credit curve, the high yield index accumulated a total return for the month of 1.35% and excess return of 0.6% with spreads ending the month 7bps tighter at 397bps.
This marks only the third month of positive excess return from the investment-grade index so far in 2004 but the momentum behind the move has been quickly lost. In the first week of August, aggregate spreads have slipped wider by those 3bps and month-to-date total return is lagging that of the Treasury index. The unequivocal weakness in the July employment report that was released last week spurred a significant rally in the risk-free markets and a widespread downgrading of second-half growth forecasts despite the fact that there is by no means a consensus that we are facing a slowdown.
The Federal Open Market Committee certainly counts itself among those expecting to see growth accelerate once more in the coming months according to the statement accompanying the second interest-rate rise of the cycle. Others, however, are less convinced and the credit markets, already grappling with the sense that the summer has given rise to a number of threats to the equilibrium of bond spreads are now trying to assess the implications of slower U.S. growth.
There is no doubt that the macro view has soured over the past few weeks and this has not helped sentiment among investors who were already being dismissive of a strong earnings season by reason of just such fears about the second-half outlook. These developments are finding their greatest expression in their effect in equity valuations but for the bond market, equity performance or lack thereof has become a risk factor in itself and the market has been afforded several reminders in recent weeks that the era when debt reduction and ratings protection were paramount is well behind us.
