The fate of the euro-zone will remain the key driver of economic performance says Iain Buckle, fixed income fund manager, Kames Capital
I recently returned to the office after two weeks paternity leave to find the market still dominated by events in the southern half of Europe. With the Greek population narrowly voting in a pro € coalition government an immediate crisis was averted, but attention very quickly switched to the, potentially much more meaningful, developments in Spain. It became apparent that large parts of the Spanish banking system required recapitalising in the wake of the collapse of their property market. With the Spanish government in no position to afford it, a hastily arranged bail-out from the collective European coffers was arranged. It did little to quell the unease, however, as investors fretted over the implications for the Spanish government’s credit rating which was rapidly approaching junk status. Only once the outcome of the latest European Union crisis summit was digested, did investor sentiment start to turn more positive.
Given this backdrop, corporate bond markets had been understandably frail in my absence. However, significant weakness was generally contained to those sectors in the eye of the storm – European banks and Southern European domiciled corporate, such as Telefonica and Telecom Italia. But despite the machinations in Southern Europe, the gilt market had given up some of its recent gains, with yields retreating somewhat from the exorbitant levels seen earlier in the year. It was following the lead of the German government bond market where investors started to contemplate the potential for common European bond issuance.
The fate of the Euro-zone will undoubtedly remain the key driver of all investment markets going forward. My personal opinion is that the market will continue to test the resolve of the core of Europe – Germany – until it is forced to make a decision on more radical changes, shorthand for common European issuance. This would involve the creation of “Euro” bonds which have joint guarantees from all members of the monetary union. To date, the Germans have been extremely reluctant to countenance common bond issuance. Their commitment to such a project would be essential as you would be relying on their economic strength to make such bonds a viable option. If the German political will behind a united Europe is strong it may end up having to accept things it currently finds unpalatable. The road between here and there may not be a particularly smooth one though.
With all that said, the current positive sentiment still radiating from the latest EU summit may last for a while. Indeed, given the elevated nature of credit spreads, high investor cash balances and paucity of new issuance then we could experience a tradable rally in credit assets in the coming weeks. Adding credit risk through keenly priced new issuance is sensible, but vigilance will be required to rotate out of exposures which have run their course.
Having hit the pause button for a couple of months the Bank of England has recently restarted its Quantitative Easing policy through another £50bn purchase of gilts. A return to the fray after such a short absence shows how concerned the Bank is about the impact of the Euro crisis on our domestic economy. However, it’s seems fair to assume the incremental impact of each slug of gilt buying diminishes. There are signs the Bank is getting more creative in its attempt to kick-start the economy through its plan to provide cheap loans for banks to pass through to small and medium sized businesses. The plan is laudable, but in all likelihood a return to sustained economic growth seems unlikely whilst the current Euro debacle rumbles on.
With gilt yields hovering near historically low levels – 1.5 per cent for 10 year gilts – it’s exceptionally difficult to make a credible case for there being great value in lending to HM Treasury. However, a combination of a very fragile domestic economy, monetary policy remaining exceptionally loose, and fresh bouts of investor risk aversion are likely to support gilts at, or around, these elevated levels for some time yet. For those taking a very long-term approach, having an underweight position in gilts has obvious merit. The extra yield you earn lending to investment grade companies continues to be attractive, with this credit spread making up the bulk of the potential return on offer from corporate bonds. Non-financial credits remain the sleep at night choice, with the exception of those located in the south of Europe. Bonds from financial institutions offer the potential for greater returns, but come with a significant notch-up in volatility.