Posted by:
Andrew Bell

23 December 2010

2010 has turned out much better for asset returns than the chequered path for sentiment at times threatened. Far from seeing the world relapse back into recession after a “dead cat bounce”, as feared in the spring, the prospect is for positive growth in 2011, at slightly slower rates than 2010, with the downgrades in forecasts seen in the summer petering out.

Recent months have been good for growth hopes in 2011, though bond investors’ antennae will be twitching at the inflation and supply risk. The fiscal boost conjured out of thin air (sadly literally) by the US Administration further underpins growth hopes, while kicking the fiscal discipline can down the road. The Federal Reserve’s QE2 bond buying programme emphasises its commitment to avoiding a liquidity crunch in the economy – contrary to many opinions, we see it as providing lubrication for financial asset and credit markets, not targeting a particular level of Treasury bond yields. Indeed, both QE1 and QE2 were accompanied by rising government bond yields, since they prompted a reduction in risk aversion and greater optimism in equity markets.

So, 2011 looks more like a further step in an unusually slow recovery rather than a threatened economic car crash. Indeed, there are possibilities that the cycle will surprise on the upside, helped by the recent additional stimulus measures in the US as well as a delayed response to the exceptionally low level of interest rates in place since 2008. These rates are needed to help borrowers come to grips with their overhanging debt but for those able to enjoy the low rates (e.g. UK mortgage payers) this process of convalescence has been underway for two years. Companies have generated cash (a protective measure against recession as well as the credit crunch) but hesitated to distribute it or invest. Both factors could be set to improve as the recovery lengthens and confidence grows in the global authorities’ intention to avoid a relapse into recession.

It is relatively easy to quantify the headwinds from fiscal tightening (the numbers are included with the policy announcements themselves) whereas the offsetting benefits from private sector investment and hiring are harder to forecast, being a result of multiple entities making decisions. A following economic wind and fading memories of the acute recession at the end of 2008 are likely to see companies more inclined to hire and invest in 2011, unless an extraneous factor upsets the apple-cart. The wild card is confidence, where the performance of politicians can be harmful.

There remain packets of significant economic stress. Nonetheless, growth appears resilient in the US, is much stronger than expected in Germany (benefiting from demand in emerging economies and weakness of the Euro) and remains strong in emerging economies.

It is in the nature of markets to worry about something new as soon as their existing anxieties are assuaged. So, if a double-dip has dropped off the radar, what are the potential flies in the economic soup? Unfortunately, they are sufficient to provide a material boost to the broth’s protein content:

• Emerging economies may be enjoying brisk economic growth but inflation is also rising, accompanied by rising interest rates. If these derail, rather than simply moderating growth, hopes for the world economy would take a significant knock.
• Markets could become restive at the apparent lack of any plan to trim the US deficit. A fiscal boost today can be tolerated if there is assurance that policy will ultimately be tightened. Congress has only raised the US Federal debt ceiling by enough to last a few months, so an outbreak of budget squabbles is likely in Q1 2011.  Since there is no consensus in favour of the required long-term fiscal tightening it is quite possible that there will be a market mini-riot to help stiffen US resolve over tax increases and spending cuts.
• A number of major US states are struggling to avert default. They are not permitted to run deficits, so once budget fudges and any Federal largesse have been exhausted, they will be forced to retrench or default. The fault line could be municipalities, where subsidies could be affected by state budget pressures. Since municipal bonds are widely held by investors, defaults would be “suboptimal” for confidence. Spreads are already widening, creating the threat of a downward spiral (as experienced by peripheral European borrowers).
• Markets may stop ignoring the burgeoning Japanese national debt. Debt at 200% of GDP may be financeable with 10 year yields at 1.2%, but the interest burden is greater than the total annual rise in nominal GDP in recent years. If Japan became the Land of the Rising Yield, the numbers would rapidly become scary. An opposition spokesman in Japan (though possibly biased) recently asserted “We’re approaching a danger zone where bond prices could plunge”.
• Europe has yet to create a decisive firebreak between the rescue packages for Greece and Ireland and other countries where bond markets are signaling concerns about the fiscal outlook (Portugal, Spain, Italy, Belgium…). Since higher market rates create a self-fulfilling outcome of either fiscal train-wreck or unachievable fiscal tightening, Europe (driven by Germany) needs to find a way of squaring its desire for ultimate fiscal discipline with the reality that for many countries the required adjustment is not immediately feasible. Crash-dieting is bad for your health. Perhaps a set of strict fiscal rules, accompanied by subsidized lending by the ECB (at say 3%) is the answer. The alternative is eventual default for a number of countries.

These are mostly specifically bearish stories for bond markets. Yields are so low that any rise in inflation will hurt, while they bear any default risk, without sharing in the upside potential of equities, if these pitfalls are avoided. Although 2010 saw new yield lows in some government bond markets, a combination of concern about sovereign defaults, reduced fears of double dips, and the inflationary implications of current policies could mark a turning point for government bond yields.

Comments or feedback are always welcome at theblog@witan.co.uk

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