In the backdrop of euro being ended up as the big loser on the currency markets in 2010, Swedish, Norwegian, Turkish and Mexican currency markets will continue to overweight in 2011, according to Dexia Asset Management 2011 outlook.
“These four economies offer very good growth figures, relatively healthy public finances and advantageous interest rates. All these factors should support their currencies – which are still far from being overvalued – in 2011 and offer euro-denominated investors attractive bond returns. The euro ended up the big loser on the currency markets in 2010, losing 7% on the trade weighted index. Fans of currency diversification were thus able to achieve strong bond returns when re-expressed in Euros. The euro’s weakness was to be expected and is warranted, given the relatively high levels it had reached in late 2009. The euro is now in more neutral territory in terms of valuation, which still leaves some currencies in the international bond indexes with room to move up,” it added.
The year 2010 was supposed to be the “exit strategy” year, with central banks and governments phasing out the anti-crisis measures taken back in 2008. In fact, 2010 turned out to be the year of sovereign risk.
While Europe was bogged down in the Greek crisis and coming up with new internal solidarity solutions to combat the debt crisis, the US made an about-face in extending its quantitative easing measures indefinitely.
In the US, the Federal Reserve has already made its choice. Faced with a 9 per cent plus unemployment rate and a sluggish real-estate market, Bernanke has chosen to jump-start US growth through asset price inflation via a second, $600 billion quantitative easing plan.
Meanwhile, President Obama’s administration decided to prolong the tax cuts introduced by his predecessor, which will raise the US budget deficit to around 10% in 2011. QE2 should keep long bond yields in check early in the year. However, with more robust growth in 2011, inflationary anticipations could get out of hand, leading the Fed to consider moving towards monetary normalisation. Against this 2011 backdrop, we prefer Treasury Inflation Protected Securities (TIPS), along with curve-flattening strategies, which currently offer an attractive risk-return profile.
In the Euro zone, it has taken time to institute fiscal solidarity between member countries. In 2011, more than ever, Europe will have to choose between solidarity and restructuring. Forced into fiscal austerity, Europe may have no choice but to offer assistance to distressed countries. The reason for this is that, with the markets bearing down on them, peripheral countries need time to implement their austerity plans, and they need low rates to fund those plans. Pressure on peripheral countries could last until a sustainable political solution emerges. As the year begins, we are underweighting all countries with heavy deficits and heavy refinancing needs and are focusing on liquidity. Once the “solidarity-restructuration” debate has been decided, the solvency story will be able to take the lead. We are therefore steering clear of heavily indebted, high-tax governments with a weak growth outlook.
In 2011, all roads will lead to public debt whether managed through growth, restructuring or solidarity, government debt levels should make investors exercise the utmost caution when choosing issuers, maturities and, henceforth, geographical regions.
“To secure protection from higher interest rates, we prefer inflation-linked bonds and flattening strategies. To play the return of solvency risk, in 2011 we prefer Finland to France, and Spain to other peripheral countries,” said Nicolas Forest, Head of Interest-Rate Strategy at Dexia Asset Management.
The year 2010 was dominated by sovereign risk and was thus a transition year compared to 2008 and 2009, which were clearly directional. It featured volatile yields and an almost 50bp widening in spreads vs. sovereign bonds during the year. The overall spread reflects a dual reality of core country vs. peripheral country issuers. Over the last year, while core country spreads remained, on the whole, relatively stable, peripheral country spreads doubled, thus illustrating the tight correlation of these credits with sovereign risk.
Corporate fundamentals are solid and will put no pressure on spreads. Earnings generation is improving and cash holdings are piling up. Certain completely deleveraged companies are likely to opt for financial strategies that remunerate shareholders more generously without compromising their
credit ratings! Meanwhile, financial establishments continue to shore up their balance sheets and to re-capitalise. However, the stricter regulations to come will rein in their profitability. In 2011, financial establishment bonds are clearly at the heart of investment grade credit returns.
On the one hand, under Basle 3, although many subordinated issues will no longer be counted as capital, they will be tolerated for a limited time. This grandfathering will come with a digressive amortisation of these issues, which will encourage the exercise of calls! On the other hand, new legislation is increasing uncertainty among debt holders. The priority is being given to protecting taxpayers from state intervention in financial establishments that are on the verge of failing. Even so, these new measures would apply only to a new type of debt issued after a certain date.
Combining these two effects shows that some subordinated quality-bank loans offer attractive narrowing potential, with some volatility in the short term.
“Our long-term outlook is still bullish, albeit far less so than 12 months ago, as companies are much further along in the credit cycle. Fundamentally, at 221 bp, valuation still looks attractive, and we are expecting a 50bp narrowing for 2011. However, as we believe that the positive catalyst for market sentiment may be another few weeks away, we are relatively neutral in the short term.”
“In 2011, our credit strategy will revolve around a positive bias on certain subordinated bank debts, with a preference for high-beta, non-financial BBB issuers and a meticulous selection of issuers,” added Koen Van de Maele, Global Head of Fixed Income Management at Dexia Asset Management.