In this week’s bulletin:
- The eurozone sovereign debt crisis may have moved to the back burner but the region’s latest victim, Ireland, will be paying the price for some years to come following the country’s most recent austerity package
- The markets’ attention turned to the unexpected stimulus package announced by President Obama following his deal with congressional Replubicans which is estimated to be worth some $900bn
- Whilst there was a positive reaction from equity markets – government debt markets in the West slumped as investors fretted over higher interest rates in response to the new growth package which is likely to stimulate inflation but also mean increased US government debt
- Elsewhere, the UK economy continues to grow faster than expected and is likely to end the year with a flourish following recent GDP estimates. China’s growth remains robust but is raising fears of runaway inflation – Beijing endeavoured to slow lending by requiring the banks to increase their reserve capital ratios
- Finally, investor worries over higher borrowing costs overflowed into the corporate bond markets – Paul Read and Paul Causer of Invesco Perpetual give their views on events.
Markets Move On
The eurozone’s recent travails have already begun to fade into the distance for global traders and speculators it seems who, once again, have found a new source of angst to be potentially exploited – the worry of higher interest rates, as we will discuss later. However, the legacy effects of this year’s sovereign debt ‘blow-up’ will continue to be lasting as peripheral eurozone governments take the red pen to their spending plans. The cost of losing investors’ confidence can be very high, as the region’s most recent victim, Ireland, has found out. Last week, the country’s finance minister, Brian Lenihan, announced a “substantial down payment on the journey back to economic health” as he slashed public spending and increased the tax burden on the middle classes. Ten days after the humiliating announcement of a €85bn bailout from the International Monetary Fund (IMF) and EU, Mr. Lenihan announced €6bn of budget savings for next year and warned that any postponement would mean even more pain. Of course, Ireland has not been the only country to be bailed out – Greece needed an emergency infusion of EU funding and the EU’s latest strategy has involved buying large quantities of Portuguese and Spanish government bonds in an effort to reduce borrowing costs for those countries. Will it be enough? Possibly, but the IMF’s Dominique Strauss-Kahn has called for a more comprehensive solution to shore up the region’s finances and calm investors’ fear. “The piecemeal approach, one country after another, is not a good one,” he said.
The Obama Boost
So, with the eurozone worries largely put on the back burner, it was left to President Obama to provide the focus of attention for the markets last week. On Tuesday, the market was given an unexpected fillip in the form of a deal struck between the President and Congressional Republicans, which effectively amounted to a second economic stimulus. The deal meant that the previous administration’s tax cuts are to be extended, along with the payment of unemployment benefits for 13 weeks, generous rules for business tax deduction and, most unexpectedly, the inclusion of a $120bn payroll-tax holiday. In all, the package has been estimated to be worth some $900bn and will help boost economic growth: with analysts at J.P. Morgan raising their 2011 growth forecasts up from 3.0% to 3.5%; and possibly higher in the view of Deutsche Bank. Whilst the US tax cut gave equities a tailwind, it will come at a significant cost, said some economists – The Financial Times pointed out that the US will be the only large industrialised country not to tighten fiscal policy in 2011 and will result in a budget deficit totalling some 10% of GDP and a government that pays for 40% of its operating costs by borrowing. Whilst the US Federal Reserve is likely to welcome the prospect of an additional short-term stimulus, rating agency Moody’s voiced its “long-term concerns” about the US credit outlook.
Unsurprisingly, the prospect of the world’s largest economy growing at a faster rate than previously thought was enough to send investors racing into commodities – gold and copper hit record highs mid-week whilst silver touched a fresh 30-year peak and US crude oil hit a two-year high of almost $91 per barrel. Optimism that the deal would boost consumer spending and offer hiring incentives to companies – unemployment remains stubbornly high at almost 10% – helped push US and European equities to their highest levels since September 2008. The mood was more muted in China and other Far Eastern exchanges as investors worried about higher interest rates being imposed by the Chinese authorities in their efforts to curb inflation – on Friday, Beijing raised the reserve ratio requirement for banks by a further 50 basis points: the sixth increase this year. But elsewhere, stock markets enjoyed gains on the back of Mr. Obama’s economic boost – notwithstanding the sudden change in mood that prevailed in world government bond markets late last week. Most of the major stock market indices – with the notable exception of Bombay where the index fell over 2% – gained traction as the week progressed, resulting in gains of around 1% or more.
Whilst equities benefited from the proposed stimulus, government bond markets remained dubious as investors mulled over the implications. More borrowing – the package adds an extra $270bn to the deficit, said economists – means more bonds being issued; specifically US Treasuries. The result was that, in the very short term, investors found their appetite for government debt sated and decided to head for the exit. So on Wednesday, US Treasuries were hit by their largest sell-off in two years causing yields to rise (as capital values fell) and thus pushing up the cost of borrowing for the US government and ultimately consumers. But the sell-off was not confined to just the US bond market: investors’ worries overflowed into the UK, German and Japanese markets too. For example, by the end of the week the yield on UK Gilts had risen to 3.6% – up from 3.0% just five weeks ago. The sharp decline in values caused hot debate amongst traders and investors as to whether the Obama deal was the catalyst – yields on developed economy debt have been rising steadily over recent weeks in any event. The primary explanation is that growth expectations have increased because of better-than-expected economic data that has become apparent in recent weeks, removing the ‘double-dip’ recession scenario that has worried the markets. Either way, the cost of borrowing has begun edging up which, to some, is unsurprising. “Yields at this level are clearly unsustainable,” was the view of Swiss bank Lombard Odier. Whilst the environment of ultra-low interest rates in the West cannot last forever, it seems it is the speed of the rise in yields that has surprised on the upside, according to The Financial Times.
Ending with a Flourish
After a moribund start, it seems that the UK economy will end the year with a flourish following news that growth gathered pace last month, with figures showing a sharp rise in factory output, raising hopes that the recovery will maintain momentum for the final quarter of the year. According to estimates from the National Institute of Economic and Social Research, GDP rose by 0.6% for the three months ending November, up from the previous month, and the research coincided with data showing that manufacturing output had jumped twice as fast as expected in October. “For now, it looks like industry is in a good position to help offset some of the effects of the looming squeeze,” was the view of Capital Economics. Elsewhere, the UK jobs market grew at its fastest rate for the same three-month period ending in November, but remains delicately poised ahead of next year’s austerity measures. Whilst the survey showed stronger rises in permanent and temporary hirings, the Recruitment & Employment Confederation said that skill shortages are beginning to emerge.
On the other side of the world, growth is going well too – in fact, the economy is probably growing a little too fast. China’s inflation surged to a two-year high last month despite government efforts to increase food and fuel supplies – the annualised rate edged up from 4.4% to 5.1% last month, according to the National Bureau of Statistics of China. The inflation figures follow stronger-than-expected Chinese trade data for November which showed exports and imports booming – both were a third higher than the same month last year. This resulted in the People’s Bank of China upping banks’ reserve ratios in an effort to slow lending and thus temper growth. Worries about slowing Chinese economic growth – with all its ramifications for the West – have caused stock markets to vacillate throughout the second half of this year. Economists consider it unlikely that China will raise interest rates significantly as this would attract unwanted, short-term foreign capital, which would potentially fuel further growth. Some argue that there is actually a silver lining from higher Chinese inflation, believing it will ultimately mean that the country would lose some of its competitiveness, which in turn would help Western exporters.
The recent rise in government bond yields mean that the inverse relationship with capital values has resulted in falling bond prices and the change in investor sentiment has overflowed into the corporate bond market too. In the very short term, investors may have seen values fall back somewhat, although this has to be seen in context with the extraordinary returns that have been witnessed in the last 20 months or so. The big question of course is what happens next. Paul Read and Paul Causer of Invesco Perpetual are recognised as market leaders in this field and here they discuss the outlook for the corporate bond market.
“Looking ahead, markets are likely to see further bouts of volatility in the short term. Both government and corporate bonds issued by members of the peripheral eurozone countries, as well as European banks holding significant positions in them, may come under further pressure. Contagion fears may at times also spread into the wider market. However, whilst the focus remains on governments with excessive debt levels, it should be remembered that there are reasons to be positive in the current low growth, low interest rate environment. Corporate balance sheets remain generally strong, sections of the market are reasonably attractive by historic standards and there is continued demand for the asset class from investors. Although yields are now more modest and interest rates will inevitably move higher from their current emergency levels at some point, we think it unlikely that they will move significantly higher over the next couple of years. There is still a huge amount of de-leveraging required, while reduced bank lending and a weak labour market will continue to restrain economic activity.
Despite their recent weakness, we still think that banks are one of the most attractive areas, particularly the larger northern European banks that we favour. Recent events do not change our view or strategy as we always thought this would be a volatile process. We think that the combination of structural reform, conservative interpretations of Basel III and rising capital levels will be a powerful support for subordinated bank debt for years to come and that aggregate yields on this type of debt still offer real value even in the context of their higher volatility. Outside of financials, we continue to see value in higher-yielding, investment-grade names and in better-quality, high-yield issuers. The aggregate yield on sterling BBB-rated corporate bonds is back above 6% at the end of November while in high yield, many credits still offer double-digit yields. So our view is that, despite the market’s recent gyrations, we have not altered our long-term view of credit markets in general and we still see areas of value and opportunity. Accordingly, we believe that corporate bond markets should continue to deliver a relatively attractive level of income going forward.”