World Markets Simplified

 

 
After a tumultuous 2011, the natural question to ask is what augurs for 2012! With that objective in mind, I summarise below two interesting viewpoints – from Bill Gross who runs the world's largest bond manager Pimco and from Robert Prince who is the co-CIO of the world's largest (and incredibly successful) hedge fund Bridgewater (which was up 25% until end-November versus -3.7% for the average macro hedge fund). Both present thought provoking outlooks which are worth giving serious consideration to:

Bill Gross:

-We are entering 2012 in a "paranormal" environment created by "zero-bound" interest rates which have created two possible "fat tailed" outcomes – either a central bank driven inflationary expansion or an "implosion" driven by delevering.

-A zero-bound interest rate environment , where rates are held at or close to zero for a significant time, creates no incentives to expand credit as flat yield curves provide limited opportunities for earning "carry" or capital gains.

- In addition, money market fund business models break-down as operating expenses exceed income leading to shifting of deposits to banks who then deposit them with the Fed in the form of reserves.

-The Fed, in its late January meeting, is likely to announce that it will keep rates at 25 basis points for 3 years or more until inflation or unemployment reach specific targets. This is QE by another name, and if it doesn't work , then a more formal QE3 is likely by mid-year. This mirrors the ECB 3 year refinancing operation, to be used by banks to fund sovereign bonds, which is a thinly disguised form of QE as well.

-In this environment it would make sense for investors to hedge their bets until the outcome becomes more clear:

-Maximise duration/average maturities as negative yields will continue with central banks holding rates at zero for a while.

-Hold US sovereign bonds in the 5-9 sector, which protect against inflation and benefit from the "roll-down" effect. Avoid European government bonds.

-Keep long term TIPS bonds to protect against inflation.

-AA and A rated credits and senior (rather than subordinated) bank paper.

-High yield stocks in sectors with relatively stable cash-flows - electric utilities, big pharma and multinationals.

-Commodities are tilted to the upside given the scarcity and geopolitical risks. Gold likely to go higher if QEs continue.

-The dollar could go either way – go up in a delevering scenario or debase in a reflationary scenario.

-Lower expectations to 2-5% long-term returns for stocks, bonds and commodities.

Robert Prince:

-The US and European economies are like "zombies" and are likely to remain like that (slow growth and high unemployment) until they reduce their debt burdens. Interest rates in the US and Europe will be locked at zero for a long time.

-Stocks will be vulnerable to "air pockets" from shocks – particularly from Europe. However, investors looking at the decade ahead could find equities to be attractive.

-Treasuries still have upside, despite low rates, and gold and Asian currencies are likely to do well as central banks continue to print money.

-The US economy is unlikely to sustain its recent better-than-expected performance as its driven by a decline in the savings rate, without material gains in personal income and employment. In addition, long-term credit growth remains weak.

-The leveraging-up period went on for 60 years- from the early 1950s to 2008 and was self-reinforcing on the way up – and with the bursting of the debt bubble the process is now self-reinforcing on the way down.

-The delevering process has hardly started with household debt to net worth being still higher than it was before 2008. Against this backdrop, the Fed will continue to buy government bonds (albeit on a sporadic basis).

Thought provoking views, highlighting the importance of keeping the macro delevering picture in mind when making investment decisions. I think this further reinforces the importance of diversity and constructing a portfolio which has something "for all seasons". A portfolio we have discussed for a while - comprising US and global energy, US and global high quality multinationals, high grade corporate and US mortgage and treasury bonds, EM (China, India and select others) stocks, select EM (saving surplus countries) currencies and bonds, gold and cash should be able to withstand the shocks while providing reasonable (5-7%) returns over a 3-5 year period. The case for having substantial exposure to emerging markets becomes even stronger with the above views (despite the underperformance in 2011) given their significantly superior debt, demographic and growth profiles when compared to the developed world. US treasury and mortgage bonds and cash will provide insurance against the frequent "air pockets" ahead of us, with corporate bonds and stock yields providing the income flows.

Regarding the global economic outlook for the year, it is clear (as Gavyn Davies points out in the FT) that the leading indicators (see graph below) point towards an improving global economy since the low point reached in the summer of 2011. It is also remarkable to note that stock markets followed the path of the leading economic indicators (which lead the economy itself) quite closely! We can therefore expect a reasonable start to 2012 with a possible slowing down again by the summer (for the reasons outlined in the two views above). The key risk remains contagion via stresses in the eurozone banking system (as pointed out by Gavyn Davies) as illustrated by Bloomberg's financial conditions indicator (see second graph below) which shows a marked deterioration in Europe (to about half the 2008 levels) – which could have been worse if it were not for the ECB's unprecedented quantitative easing via their 3 year refinancing programme. In contrast, please note the Fed's success in keeping financial conditions easy in the US.

 

 

 
GDP growth to slow; downgrades likely We expect FY13 GDP to slow to 6.8% and consensus to cut GDP forecasts over the next few months. GDP growth in the next few quarters is likely to come even lower at around 6.5%. A slower GDP will be led by: (a) a slowing global economy, (b) impact of high rates and (c) slowing investment spend.

 
China said Wednesday it opposed "unilateral" sanctions against Iran, after US President Barack Obama signed into law new measures targeting the Islamic republic's central bank.
Washington's move came after the United States, Britain and Canada said in November they were slapping additional sanctions on Iran, citing evidence that Tehran is pursuing nuclear weapons.

Tehran denies the allegations, saying its nuclear programme is exclusively for medical and power generation purposes, and China has repeatedly said sanctions will not resolve the issue.

"China opposes placing one's domestic law above international law and imposing unilateral sanctions against other countries," said foreign ministry spokesman Hong Lei in response to a question about US sanctions on Iran.

China and Iran have become major economic partners in recent years, partly due to the withdrawal of Western companies in line with sanctions against Tehran.

China and Russia — key allies of Iran — have often sought to take a softer stance on the Islamic republic than their fellow members of the UN Security Council.

 
This would stop Iran from selling 450,000 barrels to Europe every day, potentially depriving the country of 30 per cent of its oil exports. Even if Iran found alternative buyers, it would probably have to cut the price of its crude, thereby losing billions of dollars.

This possible threat to its principal source of revenue has already drawn a belligerent response from Iran, which has warned that it would respond by blocking the Strait of Hormuz, the most important link in the global oil supply chain.

On Tuesday Iran criticised the US for sending an aircraft carrier, the USS John C. Stennis, through the Strait and cautioned America not to repeat this move.

"We recommend to the American warship that passed through the Strait of Hormuz and went to Gulf of Oman not to return," said General Ataollah Salehi, commander of Iran's regular armed forces.

Last month, EU foreign ministers failed to agree an oil embargo, largely because of objections from Greece, Italy and Spain, who together buy most of Iran's crude exports to Europe.

But Alain Juppe, the French foreign minister, signalled a renewed drive to secure a ban.

"Iran is pursuing the development of its nuclear arms, I have no doubt about it," Mr Juppe told French television, adding that France had responded with a unilateral decision not to buy Iranian oil. "We want the Europeans to take a similar step by January 30 to show our determination," said Mr Juppe.

Any such embargo would amount to "biting sanctions in the real sense of the word," said Mark Fitzpatrick, a director at the International Institute for Strategic Studies. But Iran's threat to retaliate by closing the Strait of Hormuz was "bluster", he added.

"That would invite a military attack and prevent Iran's own oil from going through the Strait," said Mr Fitzpatrick.

Other observers take a different view of Iran's threats. Nigel Kushner, chief executive of Whale Rock, a legal practice specialising in international trade and sanctions, said that Iran's warning to close the Strait of Hormuz should be taken seriously.

"The Iranians would find it difficult not to take quite drastic action if the EU does ban their oil imports," he said.

The Tehran regime, riven by factionalism and infighting, has found it impossible to agree a coherent response to its increasing isolation.

"Everyone is underestimating the internal political differences in Iran today," said Mr Kushner. These divisions, he added, made it more likely the regime would retaliate for any EU embargo.

 
America has closed the books on 2011 with debt at an all time

record $15,222,940,045,451.09. And, as was observed here first in all of the press, US debt to GDP is now officially over 100%, or 100.3% to be specific, a fact which the US government decided to delay exposing until the very end of the calendar year. We wonder, rhetorically, just how prominent of a talking point this historic event will be in any upcoming GOP primary debates. And yes, technically this number is greater than the debt ceiling but it excludes various accounting gimmicks. When accounting for those, the US has a debt ceiling buffer of… $14 billion, or one third the size of a typical bond auction.

 
Governments of the world's leading economies have more than $7.6 trillion of debt maturing this year, with most facing a rise in borrowing costs.
Led by Japan's $3 trillion and the U.S.'s $2.8 trillion, the amount coming due for the Group of Seven nations and Brazil, Russia, India and China is up from $7.4 trillion at this time last year, according to data compiled by Bloomberg. Ten-year bond yields will be higher by year-end for at least seven of the countries, forecasts show.

Investors may demand higher compensation to lend to countries that struggle to finance increasing debt burdens as the global economy slows, surveys show. The International Monetary Fund cut its forecast for growth this year to 4 percent from a prior estimate of 4.5 percent as Europe's debt crisis spreads, the U.S. struggles to reduce a budget deficit exceeding $1 trillion and China's property market cools.

"The weight of supply may be a concern," Stuart Thomson, a money manager in Glasgow at Ignis Asset Management Ltd., which oversees $121 billion, said in a Dec. 28 telephone interview. "Rather than the start of the year being the problem, it's the middle part of the year that becomes the problem. That's when we see the slowdown in the global economy having its biggest impact."
Competition for Buyers

The amount needing to be refinanced rises to more than $8 trillion when interest payments are included. Coming after a year in which Standard & Poor's cut the U.S.'s rating to AA+ from AAA and put 15 European nations on notice for possible downgrades, the competition to find buyers is heating up.

"It is a big number and obviously because many governments are still in a deficit situation the debt continues to accumulate and that's one of the biggest problems," Elwin de Groot, an economist at Rabobank Nederland in Utrecht, Netherlands, part of the world's biggest agricultural lender, said in an interview on Dec. 27.

While most of the world's biggest debtors had little trouble financing their debt load in 2011, with Bank of America Merrill Lynch's Global Sovereign Broad Market Plus Index gaining 6.1 percent, the most since 2008, that may change.

Italy auctioned 7 billion euros ($9.14 billion) of debt on Dec. 29, less than the 8.5 billion euros targeted. With an economy sinking into its fourth recession since 2001, Prime Minister Mario Monti's government must refinance about $428 billion of securities coming due this year, the third-most, with another $70 billion in interest payments, data compiled by Bloomberg show.
Rising Costs

Borrowing costs for G-7 nations will rise as much as 39 percent from 2011, based on forecasts of 10-year government bond yields by economists and strategists surveyed by Bloomberg in separate surveys. China's 10-year yields may remain little changed, while India's are projected to fall to 8.02 percent from 8.36 percent. The survey doesn't include estimates for Russia and Brazil.

After Italy, France has the most amount of debt coming due, at $367 billion, followed by Germany at $285 billion. Canada has $221 billion, while Brazil has $169 billion, the U.K. has $165 billion, China (PRCH) has $121 billion and India $57 billion. Russia has the least maturing, or $13 billion.

Rising borrowing costs forced Greece, Portugal and Ireland to seek bailouts from the European Union and IMF. Italy's 10- year yields exceeded 7 percent last month, a level that preceded the request for aid from those three nations.
Bad Combination

"The buyer base for peripheral Europe has obviously shrunk at the same time that the supply coming to the market is increasing, which is not a good combination," said Michael Riddell, a London-based fund manager at M&G Investments, which oversees about $323 billion.

The two biggest debtors, Japan and the U.S., have shown little trouble attracting demand.

Japan benefits by having a surplus in its current account, which is the broadest measure of trade and means that the nation doesn't need to rely on foreign investors to finance its budget deficits. The U.S. benefits from the dollar's role as the world's primary reserve currency.

Japan's 10-year bond yields, at less than 1 percent, are the second-lowest in the world, after Switzerland, even though its debt is about twice the size of its economy.

The U.S. attracted $3.04 for each dollar of the $2.135 trillion in notes and bonds sold last year, the most since the government began releasing the data in 1992. The U.S. drew an all-time high bid-to-cover ratio of 9.07 for $30 billion of four-week bills it auctioned on Dec. 20 even though they pay zero percent interest.
Tougher Year

With yields on 10-year Treasuries (USGG10YR) below 2 percent, an increasing number of investors see little chance for U.S. bonds to repeat last year's gains of 9.79 percent. The U.S pays an average interest rate of about 2.18 percent on its outstanding debt, down from 2.51 percent in 2009, Bloomberg data show.

'Given how well they have done, we don't think they're any longer a very good hedge," Eric Pellicciaro, head of global rates investment at New York-based BlackRock Inc., which manages $1.14 trillion in fixed-income assets, said in a Dec. 16 telephone interview.

The median estimate of 70 economists and strategists is for Treasury 10-year note yields to rise to 2.60 percent by year-end from 1.95 percent at 11:27 a.m. New York time. In Japan, the forecast for the nation's benchmark note yield is 1.35 percent, while it's expected to rise to 2.50 percent in Germany, from 1.90 percent today.
Central Banks

Central banks are bolstering demand by either keeping interest rates at record lows or reducing them, and by purchasing bonds in a policy know as quantitative easing.

The Federal Reserve has said it will keep its target rate for overnight loans between banks between zero and 0.25 percent through mid-2013, and is now selling $400 billion of its short- term Treasuries and reinvesting the proceeds into longer-term government debt in a program traders dubbed Operation Twist.

The Bank of Japan has kept its key rate at or below 0.5 percent since 1995, and expanded the asset-purchase program last year to 20 trillion yen ($260 billion). The Bank of England kept its main rate at a record low 0.5 percent last month, and left its asset-buying target at 275 billion pounds ($431 billion).

The European Central Bank reduced its main refinancing rate twice last quarter, to 1 percent from 1.5 percent. It followed those moves by allotting 489 billion euros of three-year loans to euro-region lenders. That exceeded the median estimate of 293 billion euros in a Bloomberg News survey of economists. The central bank will offer a second three-year loan on Feb. 28.
'Flush With Liquidity'

The money from the ECB may be used by banks to buy government bonds, according to Fabrizio Fiorini, the chief investment officer at Aletti Gestielle SGR SpA in Milan.

"The market is now flush with liquidity after measures taken by central banks, particularly the ECB, and that's great news for risky assets," Fiorini said in a telephone interview on Dec. 20. "The market will have no problem taking down supply from countries like Spain and Italy in the first quarter. In fact, they should be able to raise money at lower borrowing costs than what we saw in recent months."

Italy's sale last week included 2.5 billion euros of 5 percent bonds due in March 2022, which yielded 6.98 percent. That was down from 7.56 percent at an auction Nov. 29. It sold 9 billion euros of bills on Dec. 28 at a rate of 3.251 percent, compared with 6.504 percent at the previous auction on Nov. 25.
'Phony War'

Investors should be most worried about the period after the ECB's second three-year longer-term refinancing operation scheduled in February, according to Ignis's Thomson.

"The amount of liquidity that has been supplied by central banks, with more to come from the ECB in February, suggests the first couple of months will be a sort of phony war as far as the supply is concerned," Thomson said.

The ECB has bought about 212 billion euros of government bonds since starting a program in May 2010 to contain borrowing costs for Greece, Portugal and Ireland. It began buying Spanish and Italian debt in August, according to people familiar with the trades, who declined to be identified because they weren't authorized to speak publicly about the transactions.

"There's a lot of talk that the ECB might have to give more direct support to the governments," Frances Hudson, who helps manage about $242 billion as a global strategist at Standard Life Investments in Edinburgh, said in a Dec. 22 telephone interview.

Following is a table of bond and bill redemptions and interest payments in 2012 for the Group of Seven countries, Brazil, China, India and Russia, in dollars, using data calculated by Bloomberg as of Dec. 29: Country 2012 Bond, Bill Redemptions ($) Coupon Payments
Japan 3,000 billion 117 billion
U.S. 2,783 billion 212 billion
Italy 428 billion 72 billion
France 367 billion 54 billion
Germany 285 billion 45 billion
Canada 221 billion 14 billion
Brazil 169 billion 31 billion
U.K. 165 billion 67 billion
China 121 billion 41 billion
India 57 billion 39 billion
Russia 13 billion 9 billion