November 3, 2012 1:40 am

Bull run brings risks and rewards

bulls on parade©Bill Butcher

More than five years after the global financial crisis erupted and on the eve of a US presidential election, the world’s central banks are still demonstrating their mesmerising grip over markets.

Mario Draghi, European Central Bank president, turned sentiment towards the eurozone after pledging in late July to do “whatever it takes” to preserve the integrity of Europe’s monetary union. Then in September, Ben Bernanke, US Federal Reserve chairman, launched a third round of “quantitative easing” to stimulate economic growth and push US unemployment lower.

Combined, their actions helped drive strong rallies in many bond markets. Investors saw the Fed as deliberately driving asset prices higher, while the ECB was acting to remove the “tail risk” of a catastrophic eurozone break-up and redenomination into weaker currencies. Monetary policy remains ultra-loose across the world.

Meanwhile, the balance sheet strength of top corporate names has further propelled a “super-cycle” that has pushed investors seeking better yields into riskier asset classes. “The ‘super-cycle’ is my euphemism for every central bank in the world being in an easing or accommodative mode and flooding the market with liquidity, coupled with manageable macro risks, strong corporate balance sheets, and tight credit spreads,” says Paul Young, head of European debt capital markets at Citigroup.

As such, the Fed and the ECB have positioned themselves as crucial backstops ahead of the closely fought US election in which the incumbent Barack Obama is fighting a strong challenge from Mitt Romney, his Republican opponent.

Coming rapidly into the focus of financial markets is the US “fiscal cliff” of tax increases and spending cuts that will take effect early in 2013. If it is not resolved, this could deliver another downward jolt to the global economy.

But the central banks’ actions have other dangers for fixed income investors. Investment strategists warn that market prices have become detached from economic fundamentals. Where investors have piled into “haven” markets – US Treasuries for instance – the danger is that the rally is not sustainable and prone to a sudden correction.

“Ironically, those who have run away from risk have put themselves in the middle of it,” warns Jim Paulsen, chief investment strategist at Wells Capital Management.

Also playing on investors’ minds are worries that exceptional monetary policy easing will lead inevitably to higher inflation – if not immediately then a few years down the track.

Such fears were a long way from the mind of Mr Draghi three months ago. Then, Spanish government bond yields were rising sharply – and two-year German yields falling into negative territory – amid fears that the eurozone’s construction was fundamentally flawed. The eurozone was fragmenting, with financing conditions varying wildly between north and south Europe.

In early September, the ECB president unveiled plans for “outright monetary transactions”, or bond purchases, to remove “convertibility premium” – the extra yield demanded by investors to offset the risk of a eurozone break-up. The aim was to make it safe to invest in Europe again.

The Fed’s motivation for action a few weeks later was different. Its concern was that a lacklustre US economic recovery was failing to generate sufficient employment. The US central bank said it would buy $40bn of mortgage-backed securities each month – and Mr Bernanke made clear that tackling US joblessness would take priority over combating inflation.

The Fed’s and ECB’s actions encouraged a “search for yield”, or assets offering a better return than sovereign debt, which was paying record low rates. A spurt of corporate bond issuance followed as companies took advantage of a surge in demand. “The corporate sector has a lot of cash. It is not leveraged and has good cover of interest rate payments,” explains Christopher Iggo, chief investment officer for fixed income at Axa Investment Managers. “There is a lot of money that wants to invest in the sector.”

Market conditions have created an opportunity to “pre-fund” – building up reserves at cheap interest rates ahead of possible turbulence ahead. General Electric, the US industrial group, last month said it had refinanced $5bn on bonds in preparation for possible “fiscal cliff” risks. “We don’t have to worry about what happens if the fiscal cliff is not resolved,” explained Keith Sherin, chief financial officer. “If it’s choppy, we’re prepared.”

Yields on European and US corporate bonds have fallen to record lows.

Such trends have created a challenging environment for fixed income investors. “You are forced into the bubble because there is nowhere else to go,” explains Mr Young at Citigroup. “Do you leave your money in a bank earning nothing, or do you buy three- to four-year corporate bonds at sub 1 per cent yields? It defies logic but it is becoming logic.”

Current, ultra-low yields on US Treasuries or German bunds – which have taken on “haven” roles in recent years – would be consistent with distinctly gloomy global economic prospects. Robert Farago, head of asset allocation at Schroders Private Banking, says that on a buy-to-hold basis “government bonds in developed countries are now pretty much priced to lose you money”.

Instead, he sees fixed income opportunities lying in more opaque markets. “We expect selected investment trusts and the hedge funds we invest in to make money where they can access private sector loans or structured credit. Credit constraints remain in many economies so it is possible to find attractive opportunities if you are willing to invest in less liquid markets.”

But there is a lot of uncertainty ahead. Last month the International Monetary Fund lowered its estimates for global growth in 2013 from 3.9 per cent to 3.6 per cent. That did not spell disaster, but it assumed EU politicians would take a firm grip on the eurozone crisis – and US policy makers would act to prevent the country’s economy falling of its “fiscal cliff,” and jolting the world economy.

As such, the outcome of this week’s US election is highly relevant for investors. A Deutsche Bank research note last week argued that a narrow victory for President Obama, the most likely outcome, would be “the configuration that has the greatest risk of generating gridlock, which we expect would be negative for risky assets and supportive of core bonds”.

Nevertheless, it went on, “our base case remains for a compromise to be ultimately reached (even if only early next year), which will imply a relatively limited fiscal tightening”.

Even if the US politicians successfully navigate the weeks ahead without widespread disruption, global challenges will remain. Europe has still to agree measures to strengthen its monetary union, and the Spanish and Italian economies remain particularly weak.

Fears, meanwhile, remain of a Chinese economic “hard landing” or a sharper than expected slowdown across emerging markets. And markets remain wary of a possible escalation of Middle East tensions.

Meanwhile, debate swirls about when worries about deflation will switch to worries about inflation.

So far there is scant evidence of price pressure building – the IMF is forecasting global consumer price inflation in the advanced economies will slow to 1.6 per cent next year from 1.9 per cent in 2012. But investors have noted a Fed bias towards tackling unemployment, and worry that at some point there has to be a counter reaction to the exceptional measures taken by central banks globally.

A common view is that politicians dealing with the consequences of excessive indebtedness have an incentive to see inflation rising.

“Our house view is that inflation will pick up, not in the next 12 to 18 months but when I see all this money being printed, it is inevitable,” says Jan Lambregts, head of financial markets research at Rabobank.

“We don’t think that we will have Weimar-style inflation but if I was a policy maker and had the choice between 2 per cent and 5 per cent inflation, I would go for 5 per cent because the debt problem looks so much better, and if I’m thinking that, I’m sure policy makers are.”

But with global economic growth prospects remaining soft and uncertainty high, few analysts expect any imminent change of strategy by the world’s central banks any time soon. As such their grip over financial markets will remain tight.

“The Fed, the ECB, the Bank of Japan – you never fight them,” says Mr Young at Citigroup. “Ultimately, markets will turn. That will get pretty ugly. But I think we can stay this way for quite a long period of time.”

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