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Credit Insights

Near-Term Deflationary Headwinds in Consumer Products

Pricing pressures have expanded from commodity-oriented products to segments that typically exhibit greater brand loyalty.

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Credit spreads were generally unchanged last week, although they went out with a weak tone Friday afternoon. The markets sold off on Friday, as the nonfarm payrolls report came in below expectations. Treasury bonds rallied, and the 10-year Treasury bond ended the week at 2.82%, the lowest since April 2009. Considering that the S&P 500 has rallied 8.7% off of the recent lows at the beginning of July, and the yield on 10-year Treasury bonds has dropped 16 basis points over the same time period, the fixed-income and equity markets continue to make very different assumptions regarding the economy's overall direction.

Morningstar's Consumer Products team has identified a pattern of deflation occurring through both the consumer defensive and consumer cyclical sectors. Within the consumer defensive sector, the team noted that pricing pressures began in the most commodity-oriented products first, such as milk and meat, expanded into categories that typically exhibit greater brand loyalty such as cereals, and have recently affected the fabric care segment. Historically, fabric care has been able to dodge most pricing pressure during economic downturns, as it has high brand loyalty and few private label offerings. Category deflation in cyclical segments, such as apparel, began early in the recession and has yet to abate. These are indicators to us that the average consumer is highly discretionary in their purchase decisions, as these lower price points are not driving incremental volume.

As we have pointed out in the past few Bond Strategist reports, short-term funding rates in Europe continue to slowly widen. This is causing us some concern that the European Bank Stress Test has not assuaged the funding markets anxiety, and may be a harbinger of renewed stress among European financials still to come. Sovereign credit spreads had initially tightened dramatically after the stress test results two weeks ago, but the tightening appears to have overextended itself, and widened slightly last week from the lows witnessed during the prior week. While the stress tests provided temporary relief, it doesn't appear to us that the funding markets and sovereign credit markets have normalized.

The new issue market was surprisingly active last week as issuers took advantage of tight credit spreads, low Treasury rates, and the market's need for additional supply. New money continued to flow into bond mutual funds, requiring portfolio managers to quickly put that money to work. The demand for new issue was so pronounced that several issues were priced without a concession to secondary trading levels (typically new issue bonds are sold at a slight discount to the outstanding bonds), and deals have been significantly oversubscribed.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.