A lot of issues are now coming to the boil in the eurozone.
It’s now evident that the problems in the periphery are increasingly beginning to impact the core. The fact that sovereign bond yields have moved up in Belgium, Austria and France is a worrying development that will ultimately put more pressure on the European Central Bank’s (ECB) bond purchase program.
We have already seen considerable purchases to support the peripheral nations; these purchases are draining reserves from the wholesale inter-bank lending market. This, in turn, has deleterious consequences for the wider real economy via reductions in bank lending and introduces the prospect of a second credit crunch.
So far, the ECB has been buying bonds on a sterilised basis using its balance sheet to fund purchases, meaning there is no increase in the money supply. With the need to support an enlarged group of sovereigns, the ECB may be forced to consider increasing the money supply to allow it to make unsterilised purchases of bonds. This policy change to quantitative easing has significant political barriers to overcome, however, principally in the form of German opposition.
The theme that has been driving bond markets in 2011 has been the reappraisal and re-pricing of peripheral sovereign bond debt. As we move into 2012, I think investors need to keep a close eye on the bond yields of Belgium, Austria and France.
In 2012, the theme driving markets may well be the reappraisal of core, AAA-rated sovereign debt. We have started to see the beginnings of this process and the markets are ahead of the rating agencies once again.
Are we entering into a final phase of the crisis?
Given we are talking about AAA sovereign nations now becoming involved, this has to be the final phase of the crisis, simply because there is nowhere else for contagion to spread.
The wave of deleveraging, and the reassessment of risk that accompanies it, will have washed right through our financial economy. While 2012 is likely to be a troubled year, the attendant volatility that we see in financial markets should also mark the last down-leg of this crisis.
The speed at which the crisis has moved from Italy to Spain and now core Europe has been alarming, but it also suggests a crescendo. The evolution of the crisis path now suggests a tipping point at which quantitative easing by the ECB becomes palatable to Germany as the only option that avoids a eurozone break up. The path between the inconceivable and the inevitable has now become very short.
How should investors be positioning themselves?
Within equities, investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends.
In Europe, dividend yields are considerably in excess of their 15-year average and there are a number of equity funds which are targeted towards this particular income-yielding section of the market; the income offers a measure of protection to investors against further market volatility. These companies are typically large, robust household names like Unilever, which may well prove to be a relatively safe place for many investors to park some of their cash, when you consider the stresses that the banking system remains under.
Investors will certainly want to be exposed to emerging markets as we emerge from this crisis.
Andrew Wells, Global Chief Investment Officer Fixed Income at Fidelity Worldwide Investment
The alarming rate with at which the sovereign bond crisis is moving has unfortunately become one of its central features. Markets, by their nature, will test any perceived weakness and now that the ECB is buying Italian bonds, markets are probing the ECB’s preparedness to deal with Spain.
The attention on Italy was largely brought to the boil by the political weakness of the Berlusconi government. The situation in Spain is different. Fundamentally, the fiscal situation is actually worse so the market focus on Spain is not a surprise at all.
One of the actions the ECB could take to stem the flow of attacks on these sovereigns is to publically discuss a yield level at which they would support Italian and Spanish bonds. This is unlikely to happen however, due to political considerations. The difficulty is that public support would effectively imply a transfer of assets from Germany to the periphery. I don’t think we can take Germany’s preparedness to write blank cheques for peripheral eurozone nations for granted by any means.
What Are The Prospects For The Euro?
Given the events that we have seen in Europe in recent weeks, the euro has actually held up unexpectedly well. There are a lot of speculators in the currency market who want to take bets against the euro, but whenever we see good news in the shape of German unemployment numbers or signs of concerted policy action, these short positions are covered and the euro snaps back.
It is debatable how much longer this can continue as news flow deteriorates. The weight of negativity against the euro is beginning to build towards a tipping point that introduces significant weakness. We are already seeing Asian investors lose confidence in the eurozone and in the euro currency itself.
Although, if we were to see a significant correction, that would in my view bring about a buying opportunity in beaten-down, yet high-quality European assets particularly in Germany and France.
Is the endgame of the crisis now taking shape?
I think we are now entering into ‘an endgame’ phase of the crisis. The solution is to get Germany to accept some inflation via quantitative easing that is unsterilised, and by that I mean that it increases the money supply.
However, this goes completely against the national psyche of the Germans, given the nation suffered a devastating hyperinflation in the 1920s that continues to echo in the collective consciousness of its politicians and central bankers today.
Unfortunately, the alternatives to quantitative easing have now been exhausted and I believe the act of persuading the Germans to consider QE has already begun behind closed doors.
Quantitative easing that increases the money supply will begin to erode the value of eurozone debts and provide respite for the eurozone region to recover.
What is the outlook for bonds as an asset class given these ongoing debt issues?
We are now in a reflationary phase of the economic cycle in developed economies that has, in fact, traditionally been associated with strong bond performance. Economic growth is slowing and inflation is coming down, quite markedly in certain areas. The challenge for investors is to understand that bonds can be a good place to be if your bond manager is exposed to the right risks.
A strategic approach is obviously paramount, particularly with regard to sovereign bonds. However, strong cases can be made for high-quality corporate bonds and inflation-linked bonds. And while they entail more risk, a good case can also be made for high yield corporate bonds on the grounds that yields have risen to distressed levels that are not borne out by relatively robust corporate fundamentals.
Many companies are in a better position than their governments now. We are seeing a reassessment of risk in bond markets and, with the exception of financials, corporate bonds can offer an attractive risk/reward payoff.
Given that I think quantitative easing and an increase in the money supply are likely outcomes once Germany’s objections become lost in the continuation of this crisis, then inflation must be considered a significant tail risk.
Right now, inflation breakevens (the difference between yields on nominal government bonds and inflation-linked government bonds – an indication of the inflation bond markets are discounting) are very cheap as we have not turned this corner on QE just yet. The problem is if you wait for the corner to be turned, you will be too late as inflation will be the word on everyone lips and the markets will react quickly to build in those new expectations.
I would certainly encourage investors to think about introducing inflation protection to their portfolios now, while it is attractively priced.
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