Magnifying an existing trend appears to be the consensus view emerging among fixed income fund managers as to the main economic effects of the terrorist attacks and subsequent retaliations. For Matthieu Louanges and his colleagues at Allianz-PIMCO, the markets have moved rapidly – over the space of a few days and weeks – to discount much of the news. He explains, “For over a year now we had been of the view that we would be entering a global slowdown, in the US and Europe and a continuation of the bad news from Japan. Our focus was on the growing structural problems in the US and the trio of bubbles that had been developing in capital investment, consumption, and in the equity markets.”
Since last summer, the team at Allianz had been preparing for the eventuality of this global slowdown. “We were positioning for a steepening of the yield curve and our portfolios were long their benchmark durations. Prior to the attacks we believed that the markets were incorrect in their assessments. Now, however, there has been such a change in the market view and the front end has fallen a great deal that our own views pretty much match what is discounted in the curve.” Consequently, they have cut back their positions and are more neutral in terms of both duration and yield curve shape.
For others, the fact that yields are already at historic lows should not suggest that the next trend must be upwards. “One might argue that the risks to bonds are one-way near-term but I would absolutely disagree. These are not normal times,” argues one investor. “We have been comparing today’s real yields with past recessionary times and they’re not that extreme. Seemingly unusual low real yields can last for months in the aftermath of recessions. I think it is still safe to be long duration, perhaps not in Treasuries because of the fiscal easing ahead. But I’d be overweight in European government bonds for the next few months at least.”
Looking ahead, Louanges suggests that the risks to their economic slowdown scenario are skewed to the downside. “We are certainly not bearish on interest rates, even if we are perhaps no that bullish either. The worry for us is that the markets are too sanguine about the economic recovery prospects for the US. There seems to be this rather comfortable consensus emerging that the combined effects of a very aggressive monetary easing and the fiscal easing will ensure that the economy will endure only a V-shaped dip in activity and will recover easily. I think it is too soon to be assuming this: we cannot yet say how the military action will develop and there is the possibility that confidence could take another blow and then we might see another flight to quality.”
Louanges believes that, as well as the uncertainties surrounding the unfolding of the military actions, there is another element which has to be factored in. He goes on, “One has to look at risk appetites in the US. There has been a huge decline in capital investment over the past 12 months and equity markets have seen huge outflows. For credit markets there are some serious implications. Not only have spreads risen considerably but also issuance has declined sharply. The global appetite for risk has already been diminished and we as investors have to try and assess future trends.”
Allianz-PIMCO is now changing the profile and taking on some more risk. “We had very little corporate exposure,” says Louanges, “and had avoided the high-yield market and indeed convertibles. Now that we have cut back on our yield curve and duration positions, we are shifting our overall risk to take more exposure to sector risk. There are opportunities and bargains out there and we have been selectively increasing our swap exposure and have also been buying convertibles and high yield.” Louanges stresses that selectivity is vital and that each position should be in names that are solid and strong must be assessed for inclusion on its own merits alone.
In terms of relative performance, Allianz-PIMCO believes that EU government bonds have the potential to outperform US Treasuries. “Although the ECB acted quickly to cut rates initially they are still quite cautious and do not appear to be in big hurry to cut rates further. In the US we have heard the Fed say that they are prepared to do anything to aid the economy and have already been much more aggressive n their easing. Bearing in mind the great support that the long end of the US Treasury market has been receiving from the prospect of a budget surplus and bond-buy back programmes, the fiscal loosening together with the monetary easing could put some upward pressure on US long yields. In Europe there may be some further widening of budget deficits but we will not see major loosening. We expect the 10-year US Treasury-Bund spread to reach +50 basis points in 2001 compared to –12bps today.”

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