Downside risks prevail
Central banks can continue their unusual monetary accommodation and government bonds prices will remain supported as long as growth stays weak and downside risks prevail over positive surprises. As private sector credit demand remains muted and inflation expectations are well-anchored, the landscape is unlikely to change this year. Although central banks can peg government bond yields at low levels for longer than impatient short-term investors can maintain underweight duration positions, we do not think that US 10-year Treasury yields will be sustained below 1.75% for long.We believe the risk that unusual monetary accommodation brings rates down to “too low, for too long” is best addressed through building long, structural inflation break-even positions and back-end curve steepeners rather than large, structural underweight duration exposures. Duration positioning in “rigged markets” is best kept tactical and light. Geopolitical risks remain high: Oil prices have been boosted by US-Iranian tension, the Syrian conflict and the possible ramifications of the Arab spring. Although a tipping point has not been reached, further oil price spikes would represent a material risk to global recovery.
Euro stands to lose in period of political instability
We believe the euro stands to lose out in an environment of increased concerns about the European Union (EU), fanned by political discord, or through ECB attempts to combat these concerns through monetary easing. A sharp decline in expected inflation may yet push the ECB toward more explicit forms of quantitative easing, although this is more a story for the second half of 2012. Marginal new lows for core yields are still possible should eurozone debt fears return in force in the second quarter. Supply remains heavy and further country credit-rating downgrades may still happen later this year.
The euro sovereign debt crisis remains unresolved. Political unity among the 17 eurozone nations, let alone the 27 EU nations, has proved hard to forge. The outcome of the French elections in May and June could further undermine the critical Franco-German relationship should plans to renegotiate the EU budget compact and add economic growth to the ECB’s mandate be maintained. Obviously, this could have far-reaching consequences.
The Greek elections, French parliamentary elections, Irish referendum, and the ratification process for the European Stability Mechanism/European Financial Stability Facility also pose risks in the second quarter. Furthermore, the Dutch minority government collapsed over an austerity drive, adding a new layer of uncertainty to Europe’s fiscal challenges.
Greece, Portugal, Spain
Just as Portugal may require a further bailout, Spain unilaterally relaxed its commitment to fiscal austerity against a backdrop of a worsening recession and an intensifying real estate downturn that raises a significant threat of further banking sector losses. Markets are wondering whether the time so successfully bought through the ECB’s long-term refinancing operations has already been wasted on policy errors over the Greek restructuring. An example is the refusal to contemplate public sector haircuts. This risks crowding out future private sector financing of the periphery through subordination concerns. The implausible claim that Greece’s finances are now on a sustainable footing and Spain’s rapid move away from fiscal austerity together undermine any credibility the EU fiscal compact may have had.
Meanwhile, recent proposed legislation banning “naked” credit default swap (CDS) short positions shows that policy makers still confuse symptoms with causes and struggle to fully understand the problems facing Europe today.
Citi US Surprise Index After peaking in January, positive surprises no longer outstrip setbacks
Corporate and emerging market debt
We think that valuations in the corporate sector are reasonable but no longer cheap. However, balance sheets are sound and both earnings and free cash flows remain quite healthy, even if earnings are starting to disappoint somewhat and defaults are projected to rise. Liquidity is also being undermined by regulatory initiatives, the impact of which is neither fully understood nor fully discounted in market pricing. This concerns the volcker Rule and Dodd-Frank on Wall Street reform and consumer protection in the US, as well as the Solvency II effects on European insurers and the Basel III rules for global banks.
We do think investment-grade and high-yield corporate debt is attractive on a longer-term basis, primarily for their yield advantage. Thus, we would prefer to wait for periods of risk aversion and wider spreads before starting to rebuild exposures. Emerging markets, particularly investment-grade EMD, remains our credit sector of choice for flexible global bond portfolios. We prefer countries and regions that stand to benefit from relative US resilience and are not overly exposed to tail risks from the eurozone crisis. This means overweighting Latin American bonds and currencies at the expense of eastern European ones.
Currencies
We think a soft landing is more or less discounted now in local currency markets and that rates have little potential to rally further. We are positioned in the short and medium dates as a result, looking to earn and preserve carry rather than capturing capital gains.
While the US dollar retains its safe-haven status, we prefer to finance EM currency positions through the euro and Japanese yen. We are structurally underweight the euro in global portfolios as it appears to be vulnerable both to an intensification of European sovereign debt concerns and to attempts to calm market nerves through greater ECB policy accommodation. As we believe that the former is likely in the short term, and the latter in the longer term, the path of least resistance for the euro appears to be downward.
We are also now underweight the Japanese yen, on the grounds of extreme valuation, official policy shifts, and deteriorating external balances. We prefer growth currencies that are closely linked to the US: our favoured currency is the Canadian dollar followed by the Mexican peso. We are neutral on the British pound sterling and Scandinavian currencies, and somewhat bearish on the Swiss franc.
Key risks
We expect global growth to track downwardly-revised expectations: there is scope for some mild disappointment, rather than shock. We do not expect to repeat the growth traumas of the second and third quarters of last year. Overall, any growth slowdown is likely to elicit further rapid policy responses and thus avert recession tail risks outside the eurozone. Growth headwinds are just brisk enough to keep growth no stronger than moderate, ensuring that super-accommodative monetary policies remain in place for all of 2012.
The key risks in 2012 thus seem to be mainly political or geopolitical. The US elections could have profound implications for the global economy and financial markets in years to come. Tensions between Iran and the US continue to build, and the risk of an unexpected significant terror event lurks in the background. Regulatory initiatives are weighing on liquidity, thereby amplifying market reactions to unexpected developments.
We expect the level of risk appetite to remain a key driver for global fixed income markets in 2012 and there are plenty of event risks on the horizon to keep markets in the volatile, and now familiar, cycle of sequential bouts of optimism and despair.
