Bond managers face a challenging environment if they are going to successfully navigate their way ...
Bond managers face a challenging environment if they are going to successfully navigate their way through the current economic landscape in Europe.
One of the biggest pitfalls facing investors is the belief that we will return to the robust economies of the late 1990's once the current geopolitical issues are resolved. The fact is the global economy, and Europe in particular, is rife with fundamental problems that will restrict economic growth even in a more stable geopolitical climate.
Specifically, there are three factors in the region that must be understood if bond managers are to add value for their clients. Since the introduction of the euro in 2000 there has been a change in the dynamic of consumption in Europe as consumers have perceived inflation to be about 2.5% higher than actual inflation. The perception of higher inflation has resulted in a higher than expected increase in precautionary savings.
The prospects for European consumption are difficult to estimate. If this perception continues, the prospect of consumer-driven growth in Europe will remain low. However, the recent fall in oil prices might trigger a change in this perceived inflation and this might entice people to spend some of their precautionary savings .
Corporate Europe continues to be burdened by a squeeze in profit margins. The introduction of the euro has resulted in more transparency in product prices and more competition. Higher commodity prices have also been pressuring profit margins in the lower tiered sectors. Finally European labour costs have adjusted more slowly to the slowdown than have US labour costs, because of the lack of flexibility provided by labour laws across Europe. The other problem for corporations is new activism in rating agencies, which are terrified they will miss the next Enron. As a result downgrades and defaults are still increasing at a faster rate than in the US.
The banking sector has been weakened a lot and you can see the beginning of a credit crunch, particularly for medium and smaller sized companies. This situation could push the corporate sector towards a tipping point whereby, if things get worse, balance sheets will be under pressure, which in turn will force the hand of rating agencies.
The difficulties in defining the outlook are compounded by the recent high volatility in two key external variables: the euro and the price of oil. The euro has been volatile in part because the US is running a 5% current account deficit, which means the dollar foundations are very uncertain and the currency that benefits from the weakness of the dollar more directly is the euro. In oil, the volatility has been tremendous and recent events suggest that even post-war, the likely increase in supply combined with continued geopolitical issues could cause further big moves in either direction.
Based on this bimodal outlook for both world and euro growth our key strategy recommendations for European bond portfolios would be inflation-linked bonds, emerging markets bonds and 30-year dated corporate debt. We think there is limited potential for capital gain on bonds because both short term rates and longer yields are close to the lows of the last 20 years.
nflation linked bonds good value.
Emerging market bonds look attractive.
Long dated European corporate debt.
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