No time to leave the bunkers yet

No time to leave the bunkers yet

Global growth has weakened further, commodity prices have eased, inflation pressures have fallen and G4 central banks remain in ultra-accommodative mode. G10 “lower for longer” commitments have not (yet) become “too low, for too long”.

Deadly embrace

Slowing inflation has allowed policy easing in developing markets, extending the nascent rally in local rates. With the relative resilience of the US economy coming into question, the Fed has extended Operation Twist and is ready to take further unconventional monetary policy measures if needed. The eurozone recession is deepening, but remains moderate rather than severe.

An intense period of political event risk in Europe (French and Greek elections, Irish referendum) is now behind us. Some limited progress was made at the end-June EU summit to address banking sector problems and, in particular, concerns over the deadly embrace of weak banks and overindebted sovereigns. However, a speedy, credible and allencompassing solution to Europe’s sovereign debt crisis remains elusive.

Any new developments for next quarter?

We are cautious on global growth. Economic data continue to disappoint, but the extent and duration of the disappointments have so far not been enough to elicit meaningful policy responses. The Fed eschewed more radical easing options at the 20 June FOMC, preferring to keep hopes alive through a modest extension of Operation Twist. Presumably they have judged that the recent very disappointing growth indicators, such as the May payroll data and June Philly Fed indices, are unconvincing.

The ECB increased its confidence in its broadly unrevised growth and inflation expectations at its June monthly meeting; we do not expect significant further monetary easing (above an already discounted 25bp repo rate cut) without either a significant tightening of broad financial conditions or a sharp worsening of hard economic data. The initially positive market response to the end-June EU summit further reduced the pressure on the ECB to act early. However, we believe the eurozone recession is intensifying and that market pressures are likely to grow, ultimately forcing the ECB’s hand, but we do not expect decisive action early in the third quarter. The BOJ has not significantly eased monetary policy. Only the UK has surprised market expectations, but the UK is too small to make much difference to global growth. China has room to ease, and has started cautiously to do so, but has not yet signalled a decisive shift towards pro-growth policies.

Lack of clarity will weigh on sentiment

Risk assets were supported in June by hopes of imminent policy support. We believe these hopes to be premature, with policy makers needing to see weaker indicators and weaker financial markets before providing more decisive support. This leaves us cautious on risk assets generally and inclined to buy duration in core government bond markets on any significant rise in yields related to short-term easing of risk-aversion fears. “Lower for longer” G4 monetary policies imply that the current yield curve regime of bull flattening and bear steepening will continue; we expect bull flattening pressures will tend to dominate in the third quarter. We remain cautious on peripheral eurozone debt, and concerned that both the ambiguities in the EU summit conclusions and the failure to agree on a clear blueprint towards closer fiscal and political integration, will again weigh on investor sentiment. Weaker commodity prices have reduced headline inflation rates. Breakeven inflation rates have been under downward pressure, creating attractive opportunities to position for the longer-term upside risks that we envisage from the increasing use of unconventional monetary policies by developed market central banks. However, catalysts for a sustained rise in inflation expectations are not yet in place; we await more decisive unconventional monetary policy measures before strengthening our structural asset allocation to inflation-linked securities.

Credit sector of choice

We are cautious, but not despondent, on risk assets: value is there but positive catalysts are not. Until we see either an exogenous recovery in global growth or a more concerted policy response, we believe this value will remain unlocked. We do favour very high quality and very short-dated spread product. After the recent underperformance of MBS*, we remain positive on this asset class in anticipation of Fed support: we believe that any notable slowing in US growth would elicit further Fed measures that are likely to involve increased MBS purchases, probably focused on lower coupon segments of the agency mortgage market. We are concerned about prepayment risk and the very high dollar prices of higher coupon MBS. We are exercising caution on HARP 2.0** eligible collateral, particularly loans that originated at the housing crisis peak through the first HArP programme and are now eligible for refinancing. The low yield environment and improved refinancing efficiency of mortgage services will produce faster prepayments over the summer. We still see good opportunities in more recently originated loan pools, particularly those with higher LTV*** ratios, which offer better call protection against prepayment risks.

We are broadly neutral on corporate bonds, both in the US and the eurozone, although we continue to overweight selected short-dated, higher quality corporate issues that show attractive carry and carry-risk characteristics.

Emerging markets (EM), particularly investment grade EM, remains our credit sector of choice for flexible global bond portfolios - but we distance ourselves from central Europe because of eurozone tail risks. Our focus stays on external debt, which benefits from attractive valuations, high average credit quality, limited issuance and resilient asset allocation demand. EM local performance has diverged from EMFx – local rates markets have rallied as inflation pressures have eased and policy makers have cut rates, while EMFx has been under pressure against a resilient US dollar. We believe EMFx has significant long-term appreciation potential against all G4 currencies, but prefer to fund positions only against the euro in the current environment.

Likely shift in market focus

The euro appears vulnerable both to any worsening of eurozone sovereign debt concerns, and to attempts to calm market nerves through greater ECB policy accommodation. As we believe the former concerns may reappear soon, requiring a more decisive ECB response in the medium to longer term, the path of least resistance for the euro appears to be downwards. We are tactically overweight the US dollar against a range of G10 currencies, and will adjust this stance over the quarter in the light of incoming global and US economic data, monetary policy responses and risk appetite signals. Sequencing is critical here, and somewhat unpredictable. We currently favour a rather defensive Fx positioning and a bias to overweight the US unit. Second quarter European elections and the EU summit may have helped to contain the range of potential short-term outcomes and averted the worst tail risks facing us, at least for now. As we move through the rest of 2012, the market focus is likely to shift somewhat away from Europe and towards the upcoming US elections, and how issues around the “fiscal cliff” are addressed. We do not expect much clarity until sometime after the November elections. However, we do expect market attention on this issue, and that related market tensions will become increasingly important drivers of global fixed income markets later this year.

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* Mortgage-backed securities
** Home Affordable refinance Program
*** Loan-to-value