In an exclusive article for Citywire Global, Newton's head of fixed income and AA-rated Euro Stars manager Paul Brain discusses the storm brewing in global fixed income.
As we look into 2012, we continue to see significant risks in the global economy, as a result of the continued effects of deleveraging (debt repayment) by over-indebted countries.
Many of the risks are associated with the fact that authorities in most developed economies are being compelled to keep monetary policy extremely loose in order to offset the dramatic fiscal austerity that is being applied simultaneously.
The extreme monetary and fiscal policy stances form a dangerous cocktail, more Molotov than martini, which is likely to have significant and unpredictable side effects.
As we navigate this volatile environment, we believe firmly that a flexible approach to investment without the constraints of being pinned to a benchmark is advisable.
While it is important to be aware of benchmark composition and movements, we prefer to maintain freedom to select our investments on the basis of their return and risk characteristics rather than their inclusion in a benchmark index.
This double-edged environment of high risk and loose monetary policy might encourage riskier markets, in the absence of any key event, to rise in value. Just like commuters who have heard a bad weather forecast, the markets will walk around wearing an extra layer to protect against inclement conditions.
This combination of extra protection and cheap funding rates could lead to modest risk-taking and more attractive returns, especially if the ‘Armageddon’ forecasters turn out to be incorrect.
Another consequence of these extreme policy initiatives and increasing political risk is that markets could become less correlated with one another.
Those more vulnerable to liquidity squeezes and government policy changes (for example Hungary) could suffer, while the search for yield could push up markets that are not afflicted, to the same degree at least, by these issues (such as Poland).
Separating the winners and the loser will define the fortunes of investors. Although it is far from perfect, this improved investment environment will be severely challenged where growth fails to live up to expectations; for now, the sun may not be shining, but at least we are not in the midst of a tornado.
We have identified money printing, rate cutting and the eurozone as the three major trends, or the wind, the rain and the fog, affecting global bond markets.
Storm in the eurozone
The potential for the eurozone to fall apart remains a pertinent concern. Fiscal austerity is in full swing in already weak economies, threatening to bring about recessions and to push government finances further into the red, while additionally compounding banking sector concerns.
For the European Central Bank (ECB) the need to offset this fiscal drag is a building storm cloud. This offsetting could be accomplished through aggressively loose monetary policy, but the ECB will only be able to implement this via the banking system.
Its three-year Long-Term Refinancing Operations will help, but their effectiveness for the peripheral government bond markets may have been over-estimated. Peripheral government bond supply during the first half of 2012 may create a challenging smog, requiring sustained demand from banks in order to be cleared.
If the prospects for the economic growth and politics were brighter, we would, in turn, be more sanguine about the prospects for peripheral European government bonds, but Greece’s Private Sector Initiative and its S&P downgrade hang over the market, creating a fog of uncertainty.
The money printing cohort (UK, US and Japan) is stuck within the eye of the storm: these markets are supported by both their ‘safe haven’ status and their central banks’ buying activity, which will offset a potential ignition in risk appetite.
We will continue to adjust duration in these markets according to overall risk appetite and economic growth expectations. At the end of last year, the US and UK bond markets rallied, pushing yields to the bottom of the range of yields on offer, and prompting us to trim some duration (interest rate risk exposure) in these two markets.
The countries that form the group of rate cutters could also offer potential to trim duration, as some of these markets, such as Australia, have started to price in negative effects of a possible Chinese ‘hard landing’. The anticipated bump following the country’s rapid growth, however, may not come about.
Some of the cash from these sales will find a home through reinvestment in emerging markets, where spread (the difference in yield compared to ‘risk-free markets, such as the US) have widened. Cash may also be reinvested once markets start to rise on the wings of future economic growth expectations.
Our overweight exposure to the US dollar is supported by our conviction that the US economy appears to be the brightest, relative to global expectations.
Normally, a revival in growth expectations would be negative for the US dollar and supportive of Asian and commodity-based currencies, but the lingering concerns about China and the eurozone have altered this dynamic.
We have chosen to re-establish a currency position in the Mexican peso, as it not only receives support from a pro-risk attitude, but its economy also benefits from a stronger US economy.
From here, we will keep a ‘weather eye’ on opportunities in other currencies that perform well during the steady economy recoveries. Given the risks that remain in the background, however, we would keep such currency positions small.
We remain cautious regarding the outlook for the global economy. Although there may be glimmers of light between the clouds, the conditions, particularly within the eurozone, remain stormy and unpredictable.
We maintain a flexible approach to investment in global bonds and in currencies, which we believe should enable us to minimise the impact of these volatile conditions, while seeking to take advantage of opportunities which may come to light.
Over the past three years, the BNY Mellon Global Bond fund has returned 28.83% and the Newton International Bond fund has returned 24.75%. This is while the sector benchmark, the Citigroup WGBI TR, has risen 22.83%.