France
When you’re electioneering you can make lots of promises, but the reality is that France now has a choice between being a part of northern Europe or southern Europe. They can become the leader of the “problem children” such as Italy, Spain and Greece or they can become the heart of Europe with Germany. For the last 60 years, France and Germany have acted together to form a strong Europe.

The reality is however as much as President Hollande wishes to be pro-growth he must be responsible – he needs Europe to remain whole and not be broken up and he needs the support of Germany in this process. The only way he can spend more money is to issue more bonds. The only way he can issue more bonds is to keep the interest rate low, and the only way to do this is to keep Germany involved.

To achieve his goals, Hollande will have to get German chancellor Angela Merkel to agree to some inflation, to open the purse strings and at the same time keep Germany happy and involved, so that interest rates are low and France can afford to spend.

So we are at an interesting point now in terms of what Hollande has promised the electorate and what he will be able to deliver. The lesson of history is that Socialist leaders in France have not been irresponsible in terms of finances – we need to make a distinction between the political rhetoric and actual financial policy. Hollande will likely ask for some compromise from Germany but not too much, in terms of relaxing austerity. Hollande is a realist. He cares passionately about the French people and the average man on the street, he does not want to destroy France. We will see higher taxes and some people and companies potentially leave France. But I think Hollande is pragmatic.

Greece
Greece is a much more dangerous situation. Here the two main political parties have lost all support. Basically anyone who agreed with the main body of Europe beforehand has lost the backing of the people. Now we have all of these small factions growing in strength and they all want to re-word the deal with Europe over their support. This may well be the cause that will see Greece break away from the rest of Europe. All of the new parties are saying they are willing to tear up the deals signed beforehand.

Greece needs to make spending cuts of around US$3 billion (A$3bn) in the next few weeks. Unless these are agreed, Greece won’t get the next tranche of funding from Europe, and if this doesn’t happen the situation becomes very dangerous.

I think most people realise that this is a tragedy for Greece but has very little impact on the rest of the world or even Europe, it is very small – but only as long as this problem can be isolated from Italy and Spain.

The risk of a disorderly exit of Greece from the eurozone has increased yes – because there is no political cohesion, Europe doesn’t know who’s in charge. It’s very hard now to get an agreement, with so many different parties and so many different deals, making it difficult to negotiate. Mrs. Merkel must be thinking what to do. If a deal is done, the government could change in a matter of weeks and we’re back to square one, it’s very tough.

However, these events have largely been priced into the bond market. The reconstructed bonds in Greece are trading way below the issue price, about 50% below. The market doesn’t believe these bonds are going to be repaid in full, but in reality there are very few retail and institutional investors involved in this market.

What is the likelihood that Greece will exit the eurozone? 

That’s a difficult question, I’d say around 50:50, but with this type of thing it’s all about politics and it’s not something you can analyse too much. Politics changes things. Public opinion is driving the agenda. If you’re a politician in Greece you must listen to the public otherwise you don’t have a job. The public are saying we don’t want anything to do with Europe.

Portugal has issues, but we believe they will stay within Europe, as will Ireland, because the support is strong and there are very few other elections coming up in the near future.

On the whole people need time. The problems of the eurozone will need working out over a number of years. We need growth, we need a re-pricing of labour in Italy and Spain, and some banks probably need more help with restructuring and bad loan portfolios. It’s very hard to see this sorted out in less than 3-5 years.

It also depends on how fast the US, Chinese and other external economies grow. If you look at recent German industrial production data, it’s quite good, the German economy is doing well. A relatively weak euro is good for Germany, so we’re seeing a transfer of assets from Germany to southern Europe. Germany is paying for a cheap euro by subsidising the periphery.

Fiscal integration would be the ultimate goal so you can have a harmonisation of taxation, fiscal policy and budgetary responsibility. That takes time and it takes time for the electorate to realise that it’s in their interest.

I think the risk of the whole eurozone system collapsing is small, as it would cause so many other problems and the cost would be huge.
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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“This is a pattern that is likely to remain in force for the early part of 2012 as markets continue to test any perceived weakness in the authorities’ preparedness to act,” suggests Andrew Wells, Chief Investment Officer of Fixed Income at Fidelity Worldwide Investment.

“I think we are now entering into a final phase of the sovereign debt crisis. A policy of quantitative easing that increases the money supply would begin to erode the value of eurozone debts and provide respite for the eurozone region to recover and reach agreements on fiscal integration. The alternatives have now been exhausted and I believe the act of persuading German policymakers to consider some form of QE has already begun.” 

Mr Wells says “given the events that we have seen in Europe, the euro has actually held up unexpectedly well. It is debatable how much longer this can continue. The weight of negativity against the euro is beginning to build towards a tipping point that introduces the prospect of significant weakness. We are already seeing Asian investors lose confidence in the eurozone and in the euro currency itself.

“We are now in a reflationary phase of the global economic cycle in developed economies that has, in fact, traditionally been associated with relatively 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.

“Aggregate bond indices and funds which are benchmarked against them now include significant concentration risks within sovereign bonds. Around half of the risk in the Bank of America Euro Aggregate Bond Index comes from sovereign bonds.

“More worryingly, the nature of that risk is highly correlated since if one peripheral nation leaves the eurozone, it increases the likelihood that others will follow.”

Mr Wells adds “while aggregate benchmarks still make up the bulk of the bond market, I think we will see increasing consideration given to more equally weighted, high quality benchmarks, going forward. I think we will see greater interest in ‘strategic’ bond funds that balance risk and return, as investors move away from products that expose them to increasingly indebted governments and institutions.

“Portfolios based on ‘best issuers’ can differentiate between government bonds, investing in the most fiscally sound sovereigns, such as Canada and Australia, as well as the highest quality investment grade corporate bonds of multi-nationals, such as Proctor & Gamble and Johnson & Johnson. Such companies benefit from multi-national reach in relation to national regulatory risks, as well as strong cashflows and healthy balance sheets. They offer better credit risk characteristics than many sovereigns and allow investors to mitigate their overall sovereign concentration risk.

“Turning to the individual bond classes, there are threats and opportunities. In government bonds, we are seeing a reappraisal of what constitutes a ‘safe haven’. Investor demand for the government debt of countries deemed to be ultra-safe such as the US, the UK, Canada and Australia has risen. With the ability to print money in their own national currencies, these bonds are considered to have low default risks by investors. However, the low yields on offer make them less attractive for investors searching for yield.”
 
He says “fortunately, the fixed income asset class is both wide and deep, so there are still very good opportunities for investors to achieve an attractive income, while avoiding threatened sovereigns. Higher-yielding parts of the bond market will retain support from investors searching for yield in an extended period of low nominal rates and negative real rates in Western economies. Coupled with aging demographics, the search for yield is a powerful force supporting the demand for high income generating assets.

“High-quality investment grade corporate bonds can offer many of the characteristics once associated with sovereigns. Generalised macro concerns have served to push up yields in corporate bonds across the whole credit spectrum, but crucially this has occurred while company fundamentals have remained basically sound. In reality, many companies are now in a better position than their governments.

“While they entail more risk, a case can also be made for high yield corporate bonds for investors prepared to take a longer-term view than myopic markets. Credit spreads now imply a significant rise in default rates, but as most seasoned bond investors know, the market rarely offers a pure assessment of fundamentals. Dislocation in financial markets periodically pushes the prices of high yield bonds to ‘distressed levels‘, which do not reflect company fundamentals. Bank deleveraging will impact the high yield market as it is a recessionary influence on the economy that squeezes the availability of credit for firms. On the other hand, this bank deleveraging phenomenon virtually assures a strong pipeline of new issuers for some time.

“In reality, most companies enter 2012 in much better shape than they did 2008/9. They have kept their cost bases under control; they continue to have access to bank lending, even if terms have become tighter, and they have actively managed their own refinancing needs in the past two years to protect themselves from this kind of volatility. These factors should contain default rates at lower levels than the market appears to be discounting. The total return of the high yield asset class is now supported by a very strong income stream – this income goes a long way to protecting total returns from this point. However, stock selection is critical to avoid the worst issues in the high yield space – these can have a disproportionate impact on returns.”

Mr Wells also notes “given that quantitative easing and an increase in the money supply are possible policy outcomes in the continuation of this crisis, then inflation must be considered a significant tail risk. Inflation-linked bonds look cheap; inflation is not on investors’ radars as we have not yet turned the corner on QE. The problem is if investors wait for the corner to be turned, they 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 at the start of 2012, while it is still attractively priced.

“2012 will also see bond investors give much more weight to the idea of emerging market bonds being a structural, rather than a tactical, allocation in their portfolios. These economies are forecast to deliver the strongest growth rates, which gives sound underpinnings to their sovereign credentials.  Indeed, the debt and budgetary positions of many emerging market countries is now far superior than many developed countries. Sharp drops in risk sentiment that lead to rises in the government bond yields of well managed, fiscally responsible emerging market countries could present opportunities for income-seeking investors. Similarly, emerging market inflation-linked bonds offer attractive real yields; inflation is higher than in the West but this likely to be more than compensated by robust growth.”
 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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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.

This document is issued by FIL Investment Management (Australia) Limited ABN 34 006 773 575, AFSL No. 237865 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS is available at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is Perpetual Trust Services Limited (“Perpetual”) ABN 48 000 142 049. Perpetual is not the publisher of this document and takes no responsibility for its content. Reference to ($) are in Australian dollars unless stated otherwise. 2011 FIL Investment Management (Australia) Limited.   Fidelity, Fidelity Worldwide Investment, the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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