Commentary: What Country Friends Is This?
The shipwrecked investor stands on the market shore and surveys a strange landscape, either brutally straightforward or maddeningly confusing depending on his or her time horizon, inherent bias, risk appetite or domicile.
For the risk, or volatility, averse the 10 year bonds of the major developed countries offer low but stable, so far this year, nominal yields and negative real yields. Those countries with substantial books of outstanding debt but control over their own currency and inherently productive economies command the lowest costs of borrowing. Yields signal that holders of US, UK, Japanese and German bonds have few sovereign default concerns, whatever the rating agencies may say. The abatement of some of these sovereign concerns have created strong short term gains in Italian and Spanish bonds as spreads over Germany have narrowed.
Cash rates in most of the major economies are close to zero, and set to decline further in Europe. The fragility of growth and persistent concerns over liquidity have offset relatively stubborn rates of inflation. Seeking income from investment assets, particularly real income, is really tough. US corporate bonds offer higher yields, currently 3.3% for credit grades and 7.3% for high yield, as do some emerging market sovereigns. Dividend yields in many equity markets are higher than the yield on their governments’ ten year bonds.
Does this indicate that the implicit investment outlook is for global economic growth to struggle to make real progress for some time, or rather that the substantial liquidity injections of QE, LTROs and perpetually low interest rates have skewed the investment outcomes over the past year or two, masking the underlying shifts?
Despite negative earnings revisions over the past three months, equities have raced ahead this year, pausing for breath at the end of February and then slumping in this first week of March. Multiples of earnings for equities are neither stretched nor bargain basement, and earnings prospects this year look soggy with sales growth slowing and margins easing from the post-2008 peaks. But economic prospects and profit growth are forecast to be better beyond Christmas.
The December LTRO by the ECB was clearly a watershed moment is removing the fear of a eurozone banking liquidity crisis from investors’ minds. The second round completed last Wednesday at a not too large/not too small €590bn and reinforced the idea that the liquidity squeeze on European banks has been removed for now. The direct beneficiaries of this year’s adjustment to risk appetites have been equity markets (MSCI ACWI up nearly 8% in dollars), peripheral bond yields (Italian 10 year up over 15%), and commodities which, using the Goldman Sachs Commodity Index, are up over 7% this year.
The sharp decline in equity markets earlier this week begs the question whether a liquidity fuelled rally has ended and the gravitational pull of weaker economic prospects will take hold. The latest bump to “growth fears” was China’s announcement on Monday of its lowest GDP growth target since 2004, lowered to 7.5% per annum from 8%. This still represents growth at a hefty clip compared with the major developed economies struggling with austerity measures to manage their debt burdens.
After a sharp and relatively smooth advance in equity markets over the past three months, and a consequent decline in investor risk measures (eg the VIX) a pause and adjustment is not so surprising – and this appears to be the message from the market recovery on Wednesday. Overall the path of recovery is a difficult one but it is in place and the overall liquidity environment is supportive, with the ECB, the BoJ and now China taking up the momentum from the Fed.
Further out there are risks that could disturb the recovery from last year’s turbulence:
- Greece could still default in a disorderly fashion with nasty knock-on effects, although this week’s apparent agreement with private debt holders is another reassuring step in avoiding this;
- There could be a supply side shock to the oil price in the event of an Iranian conflict, although the US political cycle suggests this will be avoided at all costs in 2012 by President Obama.
Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton