Debt markets have responded enthusiastically to the recovery in commodity markets, which began with the ECB’s last major monetary intervention. The average cost of credit for European materials companies has fallen from 160 to 115 bps in the four months since the mid February peak. This brings the cost to the lower reaches of the average range over the past four years, as shown in the chart below.
The fall in the relative cost of credit for material companies compared with the wider market has been just as marked. The next chart shows that while the sector is consistently more risky in credit terms than the broader market; it is a heavily leveraged industry after all; the relative cost is at the benign end of the spectrum measured over the past four years.
The improved outlook for the sector on the back of higher commodity prices is hardly a surprise and thus a reduction in implied volatility (risk) since mid-February is to be expected. Equity investors, however, remain distrustful of the sector and the risk remains at the upper end of the normal range over the past four years.
This means that on a relative basis, there has been hardly any improvement in the risk profile of the materials sector compared to the rest of the equity market. The relative risk is 20% greater than it was at the low point in early September 2015 and 15% higher than the interim low in mid-January this year.
The reduction in relative risk in the materials sector that credit investors have clearly identified, might be expected to spill over into reduced risk for the equity, which would typically mean higher share prices.