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Contagion channels and warning signs

05 July 2016
CDS, credit default swaps, credit spreads
It’s during times like these that the old crisis indicators tend to get wheeled out – metrics such as credit spreads, sovereign CDS (credit default swaps), funding spreads, etc. And this time is no different. 
It is worth keeping track of these indicators to see where market pricing is at, and if there is any trend building. The reality is though a lot of these indicators, such as the CBOE Volatility Index (VIX), often tend to spike when it’s obvious that there’s a crisis (ie they tend to be more coincident indicators than predictive or early warning indicators). That’s no reason not to monitor them, but it’s worth stating up front.
The other point is that with things like credit spreads, a spike has meaningful economic indications as it will usually mean tighter credit conditions (credit becomes harder to get and more expensive), and this is formalised in the various financial conditions indexes.
Credit default swaps and credit spreads
Sovereign CDS and corporate credit spreads show some reaction, albeit the reaction has been fairly tame by historical standards (ie not in crisis mode). 

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Financial conditions
Another key channel by which Brexit can negatively impact is financial conditions. I have included below the Bloomberg financial conditions indexes and it’s clear that financial conditions had tightened in the lead up to and immediately after the EU referendum as markets began to price in greater uncertainty. Indeed, at this point European financial conditions are registering at similar levels to back around the start of the year. 

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream
This is the other worry in regards to Brexit. Yes, there are the meaningful political implications, eg it shakes the foundations of the Euro/EU, but the other contagion channel is financial conditions. If credit spreads remain elevated, if cost of equity and debt funding remains elevated, if uncertainty is greater, then naturally it will impact on economic activity at the margin.
Bottom line 
It’s worth keeping track of risk indicators and financial conditions in the wake of the Brexit vote. At this point financial conditions appear to have tightened somewhat and risk pricing is elevated, but not dramatically so. 

This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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