THE_CREDIT_LINE：THE_LIQUIDITY_OUTLOOK_(PART_2)：STILL_IMPROVING-2012-11-14.ppt

november 9, 2012,the credit line the liquidity outlook (part 2): still improving,credit strategy research,trading liquidity is set to improve we attribute most of the august 2011 deterioration in trading liquidity to the escalation of the european sovereign crisis last fall. while none of the fundamental problems facing the euro area have gotten better, we nonetheless believe that unlike the fall of 2011, the ecb now has the necessary instruments in place to manage any re-elevation of funding,charles p. himmelberg (917) 343-3218 goldman, sachs & co. lotfi karoui (917) 343-1548 goldman, sachs & co.,pressures on the periphery sovereigns. liquidity improves when trading flows are less “macro” we conjecture that trading liquidity has suffered from elevated levels of systemic risk because “macro trading flow” is more difficult to intermediate than “micro trading flow.” in august of 2011, for example, we suspect many market makers were alarmed by the fact that european banks were suddenly looking for bids on large blocks of bonds. coming as it did on the back of the re-escalation of euro sovereign fears and the much-discussed collapse of dollar funding for european banks, it was natural to worry that even larger blocks of bonds were still to come. we find evidence that our measure of “highly correlated flow risk” is correlated with our measure of “round-trip trading costs.” when the entire market is trying to move risk in the same direction which is typically the case in face of a rapid escalation of systemic funding concerns such risks obviously increase the riskiness and difficulty of providing market liquidity. this research is focused on investment themes across markets, industries and sectors. it does not attempt to distinguish between the prospects or performance of, or provide analysis of, individual companies within any industry or sector we describe. investors should consider this research as only a single factor in making investment decisions. for reg ac certification and other important disclosures, see the disclosure appendix, or go to /research/hedge.html.,the goldman sachs group, inc.,goldman sachs global economics, commodities and strategy research,2,november 9, 2012 why trading liquidity should improve as most participants in the corporate bond market are well aware, trading liquidity deteriorated sharply during the first week of august, 2011, and remained impaired into the beginning of 2012. to track such movements in trading liquidity, we use our measure of round-trip trading costs (rttc), which we described in our march 9, 2012, publication of the credit line (“the liquidity outlook (part 1): better than it feels”). exhibit 1 displays the history of this index since 2008. the history of the rttc reveals two clear patterns. first, that up until august 2011, trading liquidity was showing steady improvement in the wake of the shock caused by the lehman default. and second, that during that first week of august 2011, trading costs rose sharply. according to our rttc measure, the median effective trading cost for investment grade credit roughly doubled to 4.64 bps by the end of august 2011, compared to its level on of 2.22 bps on the first of that month. and as exhibit 1 shows, rttc remained elevated through the first few months of 2012 before beginning to normalize. in our march 9 report, we argued that trading liquidity would improve. we have seen a slight trend better, but a better forecast would have been “sideways.” our measure of trading costs has basically been range-bound around the march level of 3.5 bps, from lows of around 3.0 bps to highs of just over 4.0 bps. we are still far, in other words, from the levels just above 2.0 bps observed throughout the first half of 2011. we continue to think that the market conditions for trading liquidity are set to improve. this is mainly because we attribute most of the august 2011 deterioration in liquidity to the escalation of the european sovereign crisis last fall, and we think the worst of that crisis is likely behind us (at least through 2013, if not longer). while none of the fundamental problems facing the euro area have become better, and the recession in the periphery has in fact gotten worse, we nonetheless believe that unlike the fall of 2011, the ecb now has the necessary instruments in place to manage any re-elevation of market tensions arising from funding pressures on the periphery sovereigns. exhibit 1: round-trip trading costs (rttc) have steadily improved since the sharp deterioration in august 2011 following the escalation of euro sovereign fears. 18 16 14 12 10 8 6 4 2 0,nov08,may09,nov09,may10,nov10,may11,nov11,may12,source: goldman sachs credit strategy, trace goldman sachs global economics, commodities and strategy research,basispoints,basispoints,3,november 9, 2012 exhibit 2: round-trip trading costs are sensitive to balance sheet funding costs,8 7 6 5 4 3 2 1 0,round-trip trading costs (lhs) term funding spread for banks (rhs),500 450 400 350 300 250 200 150 100,jul09,jan10,jul10,jan11,jul11,jan12,jul12,source: goldman sachs credit strategy, iboxx, trace. in addition to the reductions in systemic tail risks out of europe (and in part because of these reductions), the cost of term funding for banks has fallen fairly dramatically. according to iboxx data, the cost of 3-to-5 year funding for us banks, which had seen spreads to treasury as high of nearly 400 bps in dec 2011, have fallen to roughly 140 bps lower than the lows of 2011. and in our view, the cost of balance sheet funding is perhaps the most important fundamental driver of the broker-dealer communitys ability to supply market liquidity at tighter bid-ask spreads. exhibit 2 plots our trading cost measure (rttc) against the iboxx level of 5-7 year credit spreads to treasuries. in our view this chart provides fairly convincing evidence of the logical link between funding costs and trading liquidity. we also believe that systemic risk impairs trading liquidity because it causes dealers to fear “macro trading flows.” that is, flows that are characterized by highly correlated selling across all orders (in contrast to idiosyncratic flow orders). for example, in august of 2011, when credit markets are generally slow due to summer vacation schedules (and especially in europe), many market makers were somewhat alarmed by the fact that european banks were suddenly looking for bids on large blocks of bonds. coming as it did on the back of the re-escalation of euro sovereign fears and the much-discussed collapse of dollar funding for european banks, it was natural to worry that even larger blocks of bonds were still to come. we conjecture that risk of even greater amounts of “forced selling” is what caused market liquidity to dry up. we would describe this as “highly correlated flow risk.” that is, it is reasonably feasible for the dealer community to intermediate large gross flows when roughly half of these orders are “buys” and the other half are “sells.” but when the entire market is trying to move risk in the same direction which is typically the case in face of a rapid escalation of systemic funding concerns such risks obviously increase the riskiness and difficulty of providing market liquidity. it stands to reason that trading transaction costs would rise as a result. goldman sachs global economics, commodities and strategy research,basispoints,percent,4,november 9, 2012 exhibit 3: round-trip trading costs are high when macro volatility is high,8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5,round-trip trading costs (rhs) macro volatility measure (rhs),3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%,5-jul-09,5-jul-10,5-jul-11,5-jul-12,source: goldman sachs credit strategy, trace. exhibit 3 provides some evidence on the relationship between “macro trading flows” and trading liquidity. we dont measure macro trading flows directly, but rather assume (without evidence) that macro trading flows are highly correlated with macro volatility. to measure the latter, we compute the average daily stock return for the s&p 500 and use this as a proxy for the first “macro factor” in asset markets. we then compute the volatility of this index using the 20-day moving standard deviation. the result is plotted in exhibit 3, and confirms that market liquidity tends to deteriorate when macro volatility jumps. of course, this effect is hard to disentangle from the effect of spread levels shown in exhibit 2. but there is some evidence of independent effects. a simple regression of rttc on both bank credit spreads and macro volatility (all variables in 12-week changes) yields on r-squared of 0.77. both variables are statistically significant, but as exhibits 2 and 3 already suggest, the cost of term funding for banks enters more robustly. we conclude by noting that we have not yet introduced a role for regulation. we do not dismiss the impact that the volcker rule or basel-3 might have (or might yet have, since the rules are still incomplete). shorter holding periods for security inventories and higher capital charges on certain types of inventories (and their hedges) will clearly increase the cost of supply market liquidity, whatever offsetting benefits they may offer. but against this “trend” in trading liquidity there is clearly a “cycle,” and we think the near-term prospects for a cyclical improvement in trading liquidity remain positive. charlie himmelberg goldman sachs global economics, commodities and strategy research,5,november 9, 2012,our views across credit,credit fundamentals. aggregate credit metrics for north american corporations have largely reverted to pre-crisis strengths, greatly outperforming the broader economy. over the past several quarters, both margins and leverage ratios have begun to deteriorate. but they are still at very good levels. in europe, corporations continue to lag their north american counterparts, and the pace of credit deterioration as measured by aggregate downgrade measures even appears to have accelerated.,defaults. our forecast envisions a hy default rate of 2.6% for 2012. we expect most of these defaults to materialize in the ccc bucket. while credit metrics for bb-rated firms have largely reverted to pre-crisis strengths, lower-rated firms, particularly in the ccc bucket, are still struggling to deleverage. on a longer horizon, our default and downgrade view remains relatively benign. we estimate the five-year cumulative loss rate for bb- and b- rated issuers will reach 3.0% and 6.1%, respectively. these are significantly below historical averages. for ccc-rated issuers, we forecast a five-year cumulative loss rate of 32%, which is still better than the peak of the 2001/2002 recession.,investment strategy. we favor the united states over europe reflecting the difference in fundamentals. in the united states we have a tactical preference for financials over non- financials, whereas this is a much closer call in europe. across ratings we continue to prefer bb- and b-rated credit in both europe and the united states. as we discussed recently, the high end of the hy market combines attractive valuation (at least in spread terms) and good fundamentals, which makes it the most obvious beneficiary of “search for yield” motives.,goldman sachs global economics, commodities and strategy research,6,november 9, 2012 weekly picks and pans update exhibit 4: investment-grade picks-n-pans this list highlights our analysts favorite and least favorite bonds per coverage group (for more detail see “top picks and pans”, november 8, 2012). this is not intended to be a model portfolio. some bonds may differ from rated benchmark securities.,erin blum,picks 212-855-7718,bond,pans,bond,healthcare reits (neutral),health care reit inc.,5.250% 01/22,hcp, inc. healthcare realty trust,5.375% 02/21 5.750% 01/21,gregory chwatko,212-902-0673,consum er staples (neutral) retail (cautious),pernod ricard macys walgreen co.,5.750% 04/21 3.875% 01/22 3.100% 09/22,kellogg yum ! brands, inc. kroger safew ay,4.000% 12/20 3.875% 11/20 6.150% 01/20 3.950% 08/20,jason gilbert,212-902-3585,energy,pioneer natural resources,7.500% 01/20,valero energy,9.375% 03/19,(neutral),brian jacoby,212-902-3258,aerospace & defense (cautious) autom obiles & suppliers (neutral) capital goods & diversified industrials (neutral),textron inc. borgwarner inc. ford motor credit united technologies corp. deere & co.,5.950% 09/21 4.625% 09/20 3.000% 06/17 3.100% 06/22 2.600% 06/22,northrop grum m an raytheon com pany johnson controls the adt corporation the adt corporation,3.500% 03/21 3.125% 10/20 3.750% 12/21 3.500% 07/22 4.875% 07/42,honeyw ell international,4.250% 03/21,railroads (neutral),csx corp. canadian pacific railw ay,4.250% 06/21 4.500% 01/22,canadian national railw ay co. norfolk southern corporation,6.375% 11/37 5.900% 06/19,norfolk southern corporation,3.000% 04/22,raymond leung,212-357-5764,utilities & pow er (neutral),allegheny energy supply co. cms energy,5.750% 10/19 6.250% 02/20,duke energy corp consolidated edison,3.050% 08/22 4.200% 03/42,firstenergy corp.,7.375% 11/31,amanda lynam,212-902-9238,healthcare (neutral),boston scientific gilead sciences inc.,6.000% 01/20 4.400% 12/21,eli lilly medtronic, inc.,5.200% 03/17 3.125% 02/22,roche,6.000% 03/19,insurance (neutral),cna financial corp. lincoln national xl group,5.750% 08/21 4.200% 03/22 5.750% 10/21,allstate corp. genw orth financial, inc. metlife,7.450% 05/19 7.625% 09/21 3.048% 12/22,scott marchakitus,212-902-9760,telecom & cable (attractive) european telecom,am erican tow er corp. centurylink inc. vodafone,4.700% 03/22 5.800% 03/22 4.375% 03/21,cox com m unications, inc. france telecom,6.250% 06/18 4.125% 09/21,(cautious),carly mattson,212-902-6712,chemicals,eastm an chem ical com pany,3.600% 08/22,potash,4.875% 03/20,(neutral),metals & mining,n/a,nucor corp,4.125% 09/22,(cautious),paper & forest products,dom tar corp.,4.400% 04/22,weyerhaeuser co.,7.375% 10/19,(attractive),louise pitt,212-902-3644,us banks (neutral),jp morgan,7.900% perp,capital one financial corp.* morgan stanley,4.750% 07/21 5.500% 07/21,european banks (cautious),bbva ing,4.664% 7.375%,10/15 perp,credit suisse group deutsche bank ag,4.375% 08/20 3.250% 01/16,lloyds banking group plc royal bank of scotland,7.875% 6.600%,11/20 perp,reits (neutral),prologis, inc. sl green realty corp.,6.875% 03/20 5.000% 08/18,equity residential,4.625% 12/21,scott wipperman,212-357-9922,technology (cautious) media (cautious),xerox corp. cbs corp. new s corp,4.500% 05/21 3.375% 03/22 4.500% 02/21,dell inc. pitney bow es inc. viacom,4.625% 04/21 6.250% 03/19 3.125% 06/22,source: goldman sachs credit research. goldman sachs global economics, commodities and strategy research,n/a,7,november 9, 2012 exhibit 5: high-yield picks-n-pans this list highlights our analysts favorite and least favorite bonds per coverage group (for more detail see “top picks and pans”, november 8, 2012). this is not intended to be a model portfolio. some bonds may differ from rated benchmark securities.,erin blum,picks 212-855-7718,bond,pans,bond,healthcare providers (cautious) pharm a/med de vices (neutral),apria healthcare hca convatec vpi escrow corp.,11.250% 11/14 7.750% 05/21 10.500% 12/18 6.375% 10/20,vanguard health system s endo pharm aceuticals,8.000% 02/18 7.000% 07/19,kevin coyne,212-357-9918,consum er & apparel,n/a,jarden corp.,7.500% 05/17,(neutral),gam ing,caesars ent. operating co.,8.500% 02/20,wynn las vegas,7.750% 08/20,(neutral),justine fisher,212-357-6711,me tals & mining (neutral) shipping,fortescue metals group novelis navios,7.000% 11/15 8.750% 12/20 8.875% 11/17,arch coal inc. overseas shipholding,7.250% 10/16 8.125% 03/18,(cautious),airlines (neutral),air canada united air lines, inc.,9.250% 01/15 12.000% 01/16,delta air lines,7.750% 12/19,jason gilbert,212-902-3585,energy (attractive ),energy xxi gulf coast w&t offshore,9.250% 06/19 8.500% 06/19,bristow group inc. tesoro corp.,6.250% 10/22 9.750% 06/19,adam goodwin,212-902-0459,building materials,hd supply, inc.,11.000% 04/20,associated materials,9.125% 11/17,(cautious),chem icals (com m odity: neutral;,lyondellbasell mom entive specialty chem icals,6.000% 11/21 8.875% 02/18,mom entive pe rform ance materials,9.000% 01/21,specialty: neutral),hom ebuilders,beaze r home s usa, inc.,9.125% 05/19,kb hom e,7.250% 06/18,(neutral),brian jacoby aerospace & defense (cautious) franklin jarman,212-902-3258 212-902-7537,auto suppliers (neutral) technology (neutral) rental services,exide technologies first data corp. viasystem s, inc. avis budget car rental llc,8.625% 02/18 8.250% 01/21 7.875% 05/19 8.250% 01/19,allison transm ission inc. dana holding corp. sanm ina corp. n/a,7.125% 05/19 6.750% 02/21 7.000% 05/19,(cautious),jason kim,212-902-2233,cable & satellite (neutral) me dia (attractive ) telecom,dish netw ork corp. clear channel com m unications clear channel worldw ide holdings leap,5.875% 07/22 11.000% 08/16 7.625% 03/20 7.750% 05/16,mediacom llc mediacom broadband llc univision com munications, inc. n/a,7.250% 02/22 6.375% 04/23 8.500% 05/21,(neutral),raymond leung,212-357-5764,pow er,ge non inc.,9.500% 10/18,aes corporation,7.375 % 07/21,(neutral),amanda lynam specialty finance (neutral) kristen mcduffy food & beverages (a, n, c) retail (a, n, c) joseph stivaletti,212-902-9238 212-357-6157 212-902-3299,packaging & containers (attractive ) paper & forest products,ardagh packaging holdings lim ited reynolds group holdings lim ited appleton papers,9.125% 10/20 9.000% 04/19 10.500% 06/15,ow ens -illinois,7.375% 05/16,(cautious) note: we are adding the bristow group inc. (brs) 6.250% of 2022 and removing the bristow group inc. (brs) 7.500% of 2017. source: goldman sachs credit research. goldman sachs global economics, commodities and strategy research,8,november 9, 2012,exhibit 1: cdx ig term structure basis points vs. years to maturity,exh