“The past year was a good year for bond markets and we were pleased with our own performance. However,”adds SG Asset Management’s Veronica Bats, “I would be the first to admit that things did not happen quite as we had predicted. So much went on, and even now market volatility remains so high as we go into the New Year, with wild swings in investor sentiment.”
Looking ahead, Bats and her London team are forecasting a ‘not bad’ year for 2002. “Our central scenario is that the end of the recession is in sight. Our prediction is to see the US economy picking up in growth by the end of the second quarter and into the second half of 2002. But we do not believe that it will be a strong or a fast recovery and certainly will not be up to the potential but instead should be perhaps around 2.5%”, says Bats.
SG AM are concerned that the structural imbalances of the US economy, like the excess investment and debt overhang, but believe that the current policy mix is so accommodative that the recovery must be starting now.
Rajeev De Mello at Swiss group Pictet agrees that the low point in the global economic cycle has already been reached, and adds, “Government bond yields marked their lows at the start of November and I do not think they’ll be beaten. However, that sell-off that we saw later on in November was largely technically driven and not based on fundamentals – it was more about a collapsing risk-premium as investors breathed a collective sigh of relief that the situation, at least in Afghanistan, was coming under control. Equities and corporate bonds, especially the high yield did very well as the bid for Treasuries and Government bonds in general, declined.
“I think we are range trading right now – with the high and low point of the range having been set last November,” states De Mello. “But this range should be broken on the upside as we head into February, especially the 2’s to 5’s as the market takes on board the recovery story. We see the Fed signalling that it has finished easing sometime in January and that’s when the anticipation of higher rates should set in.”
De Mello argues that the long end should continue to benefit from the good inflation environment pointing out that inflation was never the issue even with the oil price blip. “We would argue that the best way to play the global government bond markets is to barbell them: long yields may nudge up but avoiding the centre of the yield curve is crucial.”
At CDC Ixis investment management, Roland Lescure agrees that on a three month horizon the safest place to be may well be the long end but cautions, “The flattening we have seen going into December is so overdone and I think the 2’s to 5’s should be best before year end. There’s little doubt that the US market dynamics have shifted to bullish equity/bearish bonds.”
CDC Ixis predict that European government bonds offer better potential than their US equivalents, arguing that because Europe’s Central Bankers, politicians and corporations reacted to the international slowdown significantly slower than in the US, then the recovery will be that much slower too. We see the 10-year US –Bund spread widening to between 60 and 80 basis points.
“We would agree with the scenario of Europe outperforming US Treasuries,” says Bats, “mainly because we think the ECB will have more easing to do than is currently discounted in the market. We think there is another 50 basis points to come by the second quarter of 2002, and so we are slightly over-invested in the three to five year area and are slightly long duration overall in Europe, whereas we are neutral in the US. This stance is part of our tactical as opposed to our longer term strategic outlook where we think neutral duration in both the US and Europe is appropriate.”
This cautiously optimistic outlook for the global economy is taken as especially good news for the credit markets, says De Mello. “A slow, steady recovery is very good for credit markets because there is no talk of expansion, or plans to invest in new capital for plant or machinery. Instead businesses are cutting jobs, retrenching to survive. Cash saved benefits their bond holders so they should be the real winners”
The diminishing political risk premia has to be good news for non-sovereign assets, points out Lescure. He goes on to say, “However, as recent events at Enron for example, have shown, an end to the recessionary environment may well be globally supportive to credit but may also bring along some bad micro-surprises with a rise in downgrades and/or bankruptcies.”
In the immediate aftermath of the 1991/92 recession the best performing asset class were the corporate bond markets, says De Mello, with equity markets taking longer to recover. He goes on, “We are still seeing a real shakeout just now with the weaker companies going to the wall, and especially the over-leveraged ones.”
And Bats believes that many companies will use the poor corporate environment in 2001 as an opportunity to reveal their bad news sooner rather than later. She cites Alcatel’s actions as evidence for this and suggests that there could be a lot of defaults waiting to happen and that the events surrounding Enron are symptomatic of the troubles that may lie ahead for the weaker companies.
In terms of sector weightings, Pictet over-weighted the badly beaten cyclicals such as autos and believe that the telecoms, although they have been doing well since their nadir in March, still offer some interesting value. “There is no doubt that the third generation licences cost these companies a great deal and their leveraging was verging on the reckless, but now things are stabilising and governments, such as the German and French ones, have been offering tax incentives or deferral of payment of their fees.”
The banks seem to have lost their attraction however with investors suggesting that their recent strong relative performance may be a thing of the past. SG AM’s Bats explains their reasoning, “We could not properly explain why the bank (credits) did not deteriorate even when the news was bad and so we would not be at all surprised when they underperform. We are happy to have a low exposure to this sector.”
“Part of the reason for the banks to have performed better during this downturn than in previous ones is that they are managed better and have generally been more careful about whom they have been lending to,” says De Mello. “That said, however, we now think that there could be some nasty skeletons in their cupboards: Enron and Swissair are two. We don’t like this sector just now because the spreads are just too tight.”