Mirror, mirror who is the fairest...
There’s always some little jargon associated with the market’s interpretation of past, present or future events. At the moment we having to use letters of the alphabet to describe the graphical shape of the hoped-for US economic recovery. U or V or L? “We think we are witnessing a bit of a turning point in perceptions,” says Pictet’s Jaime Arguello, adding: “About a month ago we agreed with the consensus view that the US economy would enjoy a V-shaped recovery, that is a sharpish slowdown followed by a reasonably quick recovery. This is still priced in to the curve, that is 50-75 basis points of further cuts from the Federal Reserve before summer.”
But Arguello now believes that the recovery shape may be more like a “U”. He explains, “In the last couple of weeks there seems to have been a change, especially on the micro-side in the form of a stream of earnings warnings. It seems increasingly clear that the US economy will not immediately bounce back, and we are revising our economic forecasts to a later recovery than we had previously thought. This means that we now expect about 100basis points of cuts from the Fed before the summer, which is not yet priced into the market.”
The managers at Carnegie Asset Management are forecasting even more aggressive cutting from the Fed. Fund manager Henning Hansen says, “There are some real problems out there, not least the decline of the NASDAQ below 2000. At the moment we think the Fed will do between 100 and 125 basis points, and that this magnitude of rate reduction should be sufficient. Our central forecast is that the US economy, and the equity markets will be stabilised and that the lower rates will boost both the consumer and the corporate sector. And don’t forget that the lower oil prices will be helping too.”
Both Pictet and Carnegie are forecasting a steepening of the US yield curve, almost entirely due to the decline in shorter rates. Carnegie’s Hansen explains, “Short rates will continue trending lower as the Fed carries on cutting. Long rates, on the other hand have very little reason to move. There is still absolutely no sign of inflation now or in the foreseeable future, so why should there be a dramatic increase in bond yields just as the economy begins its (not very strong) recovery?”
For Indocam, the outlook for Treasury bonds is rather less cheerful. The group says, “Although we have scaled back US GDP growth forecasts for 2001, because we think there is more economic evidence to support this weaker outlook, we still see a benign landing scenario in the end. We are, however, maintaining our moderately negative stance on bonds. Our feeling is that the global ‘risk aversion’ state that we are currently in will begin to melt and will trigger flows out of safe-haven government bonds.”
That bond markets have indeed benefited from the risk reducing activities of investors worldwide is evidenced by the analysis of recent mutual fund flows data. “Within Europe, retail inflows to equity funds slowed very sharply in January and appears to have weakened even further in February, matched by lower outflows from bond funds,” says Schroders Salomon Smith Barney’s Michael Saunders in a study. He goes on to point out that retail demand for bond funds has not surged as far as in the US. Retail inflows to bond funds there surged to $10.1bn (e11.2bn)in
January this year, the highest since the late 1980’s.
Saunders uses this flow information to back up his idea that the US Treasury market is, and will continue to do so, enjoying considerable support from the flows on to the mutual funds, so much so that US Treasuries will continue to outperform their European counterparts.
Useful though the study of these flows undoubtedly is, he cautions that the swing away from equity funds on both sides of the Atlantic, is probably a lagging effect of last year’s market trends. “Retail investors overall tend to be momentum investors, investing in assets that have performed well and selling assets that have performed badly. Retail investors now are responding to last year’s poor returns by seeking the safety of money market funds,” he suggests.
Not all fund managers agree that European Government bond markets hold less allure than that of the US, although there is not much in it. Arguello at Pictet suggests that with the ECB lagging the curve in its over-optimistic assumptions about the prospects for European growth there will end up being more cuts than currently priced in. He adds: “As in the US we think the short end will outperform the long end as the curve steepens. On balance we actually think there is slightly more to go for than in the US.”