In this week’s bulletin:
- More of the same for markets as eurozone and US fiscal cliff fears unnerve investors, although US Congress shows surprising unity and Japan bucks the trend on the back of further stimulus hopes.
- China’s new leader acknowledges the challenges of stimulating the world’s second largest economy and shifting the country’s growth model towards domestic consumer demand.
- Amidst talk of a ‘bubble’, our fund managers give their views on the sustainability of the good run for bonds.
- Concerns over the eurozone and US fiscal cliff continued to dominate market sentiment last week
- Japan bucks the trend as its stock market rallies on hopes of further fiscal stimulus to boost the economy
There was ‘more of the same’ for investors last week: ongoing concerns over the eurozone and the so-called US ‘fiscal cliff’ dominated market sentiment. These worries were compounded in the short term by geopolitics, as Israel continued its retaliation against Hamas militants in Gaza, causing oil prices to tick higher. Bucking the trend was Japan, where expectations of further QE and stimuli for the economy, to avoid yet another recession, caused the yen to weaken but boosted the country’s major exporting stocks: the Nikkei 225 Index ended the week some 3% higher. Disagreement between the IMF, EU and ECB meant that eurozone ministers delayed paying out a much-needed tranche of bailout money to Greece, increasing the chances of default. The Troika’s disagreement centres on how soon Greece should aim to reduce its debt-to-GDP ratio to 120%; observers believe the difference between whether it is 2020 or 2022 is largely academic, with the real issue being about a potential write-down of public debt by the authorities. Investors’ nerves were further tested with news that the eurozone as a whole had slipped into recession in the last quarter.
On the other side of the Atlantic, investors on Wall Street decided to remain on the sidelines, preferring the safety of Treasury and corporate bonds, as poor employment data aggravated worries over the current negotiations between President Obama and Republicans about the impending tax increases and spending cuts due to kick in next month. Official figures showing a jump in jobless claims – some 78,000 – were unexpected but attributed mainly to the effects of America’s superstorm Sandy, with economists expecting claims to normalise over coming weeks. So, as sentiment was buffeted by these fiscal and economic headwinds, it was no surprise that most major equity markets gave ground over the week, with even the allure of gold failing to tempt investors.
Winds of change
Last week witnessed the once-in-a-decade handover of power within China’s ruling Communist Party as the country’s new leader, Xi Jinping, took over the reins of power. Mr Jinping takes over at a difficult time, a point he made in his acceptance speech, as the world’s second-largest economy endures a slowdown coupled with the need for social reform. China registered annualised growth of 7.5% last quarter, down from over 10.0% a year previously; and, according to analysts at Standard Chartered, growth could fall further without fresh reforms to lessen dependency upon the state, thus allowing market forces to boost growth. Investors have already registered their concerns if the Shanghai stock market is to be seen as an indicator; it has fallen 18% this year and is the worst performer among its other BRIC counterparts, Brazil, Russia and India. So, with the growth model losing steam, the new leaders, unlike their predecessors, do not have the luxury of an economic boom to fall back on. To tackle this, Mr Jinping is intending to shift China’s growth model away from exports and investment towards domestic consumer demand. But this will take time and economists are taking the view that recent measures to stimulate the economy will help underpin growth, allowing the new leadership time to introduce the reforms needed.
An attack of vertigo
- Looming ‘fiscal cliff’ deadline focuses the minds of both Democrats and Republicans to avoid further brinkmanship over impending tax increases and government spending cuts
- Initial discussions strike unexpected note of uniform optimism
“We’re going to do it now… this isn’t something we’re going to wait until the last day of December to get it done.”
Senate Majority Leader, Harry Reid
It seems that, having looked over the edge of America’s fiscal precipice, investors don’t like what they see and have decided that, for now, there are safer places to be. On Wall Street those fears have manifested themselves in a simple strategy: sell shares and buy bonds. Just to recap, the US faces a combination of tax rises and government spending cuts equivalent to fiscal contraction of some $650 billion, which is equivalent to some 4.2% of GDP. These changes have already been legislated for and will automatically come into play at the end of this year, so if there is no political agreement there is a possibility that the economy could grind to a halt and probably go into reverse. Unsurprisingly, most think this scenario is highly unlikely but, notwithstanding this, the very fact that time is running out has unsettled equity markets, causing greater price volatility.
Despite the fact that the fiscal cliff is a legacy of a bitter two-year war over the US budget between the Democrats and Republicans – who control Congress – there is an acceptance on both sides that a deal needs to be done. Some argue that revenue needs to come from higher average taxes and not just higher marginal tax rates if higher government spending on social care is to be maintained. Flowing from this is the possibility of a scaling back of tax relief on mortgage interest, which costs a staggering $130 billion a year, although this might impact on the funding of big-ticket items such as cars and cruises, paid for by equity withdrawal. Higher dividend taxation along with corporate tax reform have been mooted. But at the top of the list is President Obama’s insistence – vehemently opposed to date by the Republicans, and this could remain the one serious sticking point – that, irrespective of this, tax rates must rise on the wealthiest Americans.
However, at the end of last week, US Congressional leaders struck an unusually uniform note of optimism following their first official talks with Mr Obama. Republican leaders John Boehner and Mitch McConnell said they had put extra revenues on the negotiation table: a contrast to their pre-election rhetoric. “While we’re going to continue to have revenue on the table, it’s going to be incumbent for my colleagues to show the American people that we’re serious about cutting spending and solving our fiscal dilemma,” commented Mr Boehner. Barack Obama’s convincing re-election has strengthened desire for a solution on the part of the Democrats too, as both sides seek to avoid further brinkmanship. Harry Reid, the Democrat leader in the Senate said, “We’re going to do it now… this is something we’re going to wait until the last day of December to get it done.” Analysts believe that, whilst the resolution of the issues might mean a cut in both government and household expenditure, it is also likely to lead to a significant release of corporate cash that has been stockpiled because, for America’s CEOs, their one big focus is corporate tax reform.
Bonds remain buoyant
- Government and corporate bonds remain hugely popular with investors seeking lower risk and have produced excellent returns in recent times
- The big question is: will the good run continue?
As mentioned, current headwinds have caused institutional investors to favour bonds over equities and, whilst these flows are likely to be short term, investing in government and corporate bonds following the financial crisis has been very popular for private investors too. Traditionally, bonds – IOUs issued by governments and businesses – have been viewed as a lower-risk investment in times of global economic uncertainty. Indeed they have produced excellent returns over recent years. The great appeal of bonds is the regular, fixed level of income they provide. Once issued, bonds can be bought and sold on the open market, with the price determined by supply and demand. Increased demand has pushed up prices, which means yields – because of their inverse relationship – have fallen sharply, as the chart below illustrates. This year has seen a record issuance of corporate bonds – some $1.6 trillion – and huge demand from income-hungry investors has pushed up the prices, particularly at the very high-yield or ‘junk’ end of the market. Against this very buoyant backdrop, the question increasingly being asked, though, is: will the bull-run continue or is it drawing to a close? To answer this we asked our corporate bond managers for their views.
Source: Bloomberg. Data to 16 November 2012.
Ken Buntrock of Loomis Sayles commented, “In this enduring environment of zero policy rates and low yields on high-quality bonds, we believe the search for yield will remain a key theme in 2012 and 2013. This environment suggests bonds across the quality spectrum trading at a premium to government bonds could achieve respectable risk-adjusted returns.” Paul Read at Invesco Perpetual gave his views: “With low growth and inflation expected to fall, we expect interest rates to be low for several years and there is still the possibility of more quantitative easing, which could keep a lid on government bond yields. While we do not anticipate a significant sell-off in government bonds, generally speaking we do not see there being value in most government bond markets. Global growth expectations are improving and the threat of deflation has receded – conditions that should see yields rise further. In these conditions, we expect corporate bonds to outperform government bonds. Bubbles are based on hope and speculation leading to valuations that are divorced from reality and an eventual permanent destruction of capital. In bond markets, yields are extremely low, but this reflects the low short-term interest rates, uncertainty surrounding the sustainability of the economic recovery, low deposit rates and continued demand for the asset class from investors.”
Neither does Zak Summerscale, of Babson Capital, see signs of excess. “With gross yields in excess of 7%, we see little signs of a bubble in senior-secured bonds, driven by a continued need for banks to reduce risk to the corporate sector, which is driving new issuance and keeping yields at attractive levels. Whilst corporate bonds have become an increasingly popular institutional and retail asset class since the financial crisis, the vast majority of inflows have been targeted at the investment grade sector given such low yields on risk-free sovereigns, and much less so at senior-secured bonds. Whilst risk assets are likely to remain volatile, driven by macroeconomic headwinds, we continue to believe that investors are over-compensated for the fundamental risk on senior-secured bonds at today’s pricing.”
Clients should continue to diversify their investments by asset class, geography and fund manager style in a way that is commensurate with their attitude to risk and investment objectives.