“Investors need to be careful before rushing into fixed income assets to escape equity market volatility,” cautioned Andrew Wells, Global Chief Investment Officer, Fixed Income, Investment Solutions and Real Estate at Fidelity Worldwide Investment.

“Tight liquidity has driven a lot of the recent appreciation among some bonds.

“We have seen substantial flows into traditional safe havens such as US 10-year T-bonds and German Bunds, but long-term the current levels of these interest rates are unsustainable. They may appreciate a little more, but fair value for inflation and other risks is probably some way below where they are now.

“Rather, we have seen investors moving into other high quality bond markets such as Canada and Australia, in an effort to escape eurozone uncertainty.

“Investors are also increasingly moving into credit in the investment grade space, as corporate profitability is strong at the high-end and balance sheets have improved. Some high-quality companies are looking better than some governments,” said Mr Wells.

“We’ve also seen an increased appetite for Asian bond markets, as many Asian economies do not have the same debt problems faced by the eurozone and many other developed markets. In particular, demand for Asian investment grade bonds is increasing. Investors are also looking at Chinese RMB bond funds, where the appreciation of the currency is now available to global investors.”

Dominic Rossi, Global Chief Investment Officer, Equities, at Fidelity Worldwide Investment added: “Asia’s increased bilateral trade offers some protection from downturns among the bigger developed markets.

“However, financial markets have not developed quite as quickly and Asia is still dependent on foreign capital, from equity markets in particular. Although much better insulated than 20 years ago, volatility persists due to the impact of foreign capital inflows and outflows. It will be many years before the wider Asia region develops a deeper domestic savings pool to defend against today’s exogenous factors.

“This volatility is the key obstacle to a rally in equities,” he said. “Equities are cheap, not because earnings are low – in fact corporate profit margins are actually very strong – but because volatility is deterring fresh investment flows. With volatility hovering above 20% it’s very difficult for equities to attract and compensate investors for such high levels of volatility.”

Mr Rossi suggested there were four key issues to address before a rerating of equities can take place:

1. Bank deleveraging in Europe – most banks in peripheral areas of Europe still have loan-to-deposit ratios in excess of 120% and are without access to wholesale funding. These banks must make further progress and this will likely take years rather than months. On the positive side, transparency is improving and non-core asset sales are progressing.
2. Eurozone debt crisis – we expect to see weeks and months of negotiations over policies and access to bailout funds. Greece’s underlying competitive issues remain unresolved. Spain and Italy have already come under increased market pressure and the European Union will need to produce a debt restructuring program for Spain. There is a lot more work to be done in these markets.
3. US “fiscal cliff” – although markets are mainly focused on the eurozone, I expect the US fiscal situation to make the front pages before the end of this year. The Congressional Budget Office has already warned that if the US Congress can not agree on spending cuts, they forecast a contraction of economic activity in the first half of next year. If this happens, we should expect 2013 earnings estimates for US companies in the S&P 500 Index to come down from current levels.
4. Commodity prices – there’s an inverse relationship between commodity prices coming down on one hand and equities being rerated on the other. While prices have come down, we need to see an across the board decline in commodity prices before monetary authorities can ease policies further and we see a depreciation in currencies.

“In the meantime, as these issues are worked through, we believe a strategy for investors to focus on is capital preservation with a particular focus on equity income and appropriate fixed income.”

25 June 2012

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