Bonds' fate hang on US recovery
Last year was a challenge, not least for equity investors who saw their markets suffer double digit declines across the world. Although bonds, some more so than others, were generally the better investment last year, it seems that they may have to move out of the limelight in 2002.
Bonds have had their day, sighs Dublin-based Setanta Asset Management’s John Looby, adding that equities look set to have a good run in 2002. “We are at the beginning of a sustained recovery in activity in the US and official rates are at or very close to their trough. I see yields rising across the curve but most especially at the front end,” Looby goes on to suggest that the rising trend at the front end should mark the reversal of the sharp declines in short rates experienced over the past 12 months or so and should take yields to less extreme and more normal levels.
For strategist Peter Van Doesburg at Dexia Securities in Amsterdam this optimism on the US economic recovery is a little too hasty. “For me, it is not clear whether the economy will continue to recover so steadily. I agree there are some clear signs that activity is picking up, especially in both producer and consumer confidence, and November’s US consumer credit figures showed the largest ever monthly increase, for example. However, I am sure we will see an offset to this extraordinary strength and I just feel it is too early to be extrapolating the strong figures across the entire economy.”
Paul Cavalier, head of fixed income at Lombard Odier in London suggests that it is too soon for anyone to be making up their minds either way. “The latest Merrill Lynch survey of US Federal Reserve analysts revealed the most diverse set of opinions ever recorded. There has been such an aggressive sell-off at the end of last year that it is very difficult to have very firm opinions either way,” he argues. “We do believe that the markets have got it about right just now, and that the US economy has bottomed and that 2002 should see it record sub-trend growth of 3–3.5%.”
But Looby is not convinced, arguing: “I am sure that the economic recovery will be stronger than the market expects. What are the constraints on it? And why should consumer spending be weak? Obviously there has been and will continue to be real weakness in the investment side, but companies will grow their profits by cutting their costs and investment spending will increase eventually. This is where I believe there is the most potential to surprise on the upside.”
The market is predicting that the Fed will be looking to hike rates this year. Lombard Odier is happy to go along with the market. “The Fed had clearly been slowing down its easing of monetary policy, but then 11 September happened and Greenspan had to react. He will now need to undo that ‘insurance premium’ this year,” says Cavalier.
Although disagreeing on the nature of the recovery in the US, there is a consensus view that the European economy will continue to track that of the US, maintaining its six-month lag. It is less likely that the ECB will be looking to hike rates, says Lombard Odier, which argues that as the ECB had not put in the emergency measures in September, there is not the pressing need to undo the insurance easing as in the US.
Van Doesburg goes further and argues that the European economies will need further stimulus from monetary policy. “The US economy is very much more flexible than ours,” he states, “and where the US is able to resolve issues speedily, here in Europe things are much less easy to resolve. It is much harder to lay off workers here, for example and labour mobility is much more restricted. It is not hard to see the European economy continuing to lag the US and for its recovery to be weaker too.”
Although sceptical that the US economy can maintain a smooth recovery path, Van Doesburg is quite nervous of possible repercussions resulting from the massive liquidity injection from the Fed. “Yes, I am worried – the liquidity must surely result in inflation appearing in the system, and somewhere along the line we will probably see real imbalances emerging. Inflation is not around in the real economy, but this liquidity ingestion makes me quite uncomfortable for the general outlook and puts me on my guard.”
The team at Lombard Odier feel this is too cautious a stance and instead suggest that, as far as yield curves and duration bets are concerned, that there is little to get too excited about. Cavalier goes on: “We think the US yield curve should flatten in the longer term, as the Fed reverses its post-11 September actions. But supply is another issue – will the US pass the tax cuts? For the very long end, ie, the 30-year, issuance will not be a problem and so we do not see yields rising so much here. For Europe’s government bonds, we think there will be less flattening as official rates have less far to increase. All in all we would argue that there needs to be a more obvious picture of what might happen and we would not be advocating any big bets on either yield curve shapes or duration.”
“Amidst all the uncertainties, we feel the greater risk is probably to be long, and that we would probably be better sellers of rallies,” says Cavalier, adding: “There are perhaps some worrying similarities between the technical trends today and those of early 1994.”