The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets

The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets is lasting longer than anticipated.

Moreover, “we are close to very critical levels which might squeeze out the “last bear standing”. This would be the end of the bear market rally!”

The most common arguments why the worst should already be behind us are the following, says Dr Felsenheimer:

i) the recapitalization of the global banking system is in full swing and the fact that financial institutions are able to raise capital in such difficult times shows that the banks are on their way out of the subprime swamp.ii) loss-estimates are exaggerating the severity of the crisis as many losses are only m-t-m losses. Pull-to-par will reduce losses over time, even generating valuation gains in the future.

iii) companies are still in very good micro-fundamental condition. Default rates will not climb to 2002 levels as balance sheet leverage of nonfinancials is not a major threat in this crisis.

But not so fast, because something is different this time - and that’s good news for bears. In other words, the light at the end of the tunnel is the locomotive which is on a confrontation course and will hit us soon:We think that further spread widening is highly likely. While we do not ignore the possibility that we have already seen the spread highs in the synthetic (overshooting) markets, we think that especially cash non-financial spreads will come under pressure.

What could be the impulse for the next widening leg? As already seen two times in 2007 (when officials prematurely proclaimed the end of the crisis), the impulse might come from a side which is right now not on the agenda. In our view, a disappointment on the macro front is the most obvious potential source of further adversity for credit markets.

And it gets better (or worse, depending on whether you’re long or short the iTraxx Crossover):

The latest improvement of sentiment looks to us as wishful thinking rather than marking the spread reversal in credit markets. Many problems are still there and a solution will take longer than currently anticipated. Even US officials are less optimistic than many investors (shareholders). The head of the US Federal Deposit Insurance Corporation said that another wave of more traditional credit stress (linked to an economic slowdown) could come, including mortgage loans.

In addition, there is again bad news from the usual suspects: a Canadian court delayed yet again the restructuring decision for Canadian ABCPs. This is not a big thing, but it will further delay the full re-functioning of the Canadian CP market.

All these arguments are pointing to a longer-lasting problem, which will probably not result in a failure of a big financial institution and not in a fully-fledged credit crunch; but it will have a lasting negative impact on the earnings generation power in the financial industry and weaker growth which will be worse than the slowdown in a “normal” business cycle. This scenario, in our view, is not fully discounted in credit spreads, especially not in synthetic ones.