Investors should be prepared for an inflation snap back
* Calls for quantitative easing have increased as the global growth outlook has weakened
* Investors are underprepared for a snap back in inflation
* Investors need to carefully review the benchmarks their fund managers are using.
* Exposure to financials and some governments comes with significant risk
Stock markets in the US and elsewhere have been firmer in recent days as investors look ahead expectantly to Ben Bernanke's speech at the Jackson Hole Federal Reserve symposium in Wyoming on Friday.
In this latest Portfolio Manager Perspective, Andrew Wells, Global CIO, Fixed Income at Fidelity International, discusses the renewed calls for further quantitative easing, the risks to currencies and the possibility of a sharp inflation snap back:
Recent events have rattled confidence and although the global economy is not in recession the probability of such an event has clearly risen. Recently, US Treasuries briefly dipped below 2.0%, which reflects how nervous investors are right now. Maintaining plenty of liquidity and making careful credit selection is vital right now. Inevitably, as the global slowdown deepens, there have been renewed calls for more quantitative easing. But now the bar is much higher than it was during previous rounds of stimulus. Inflation expectations are rising and doubts have emerged over how effective additional stimulus would be as developed economies are already awash with liquidity.
Quantitative easing has been blamed for debasing currencies in the developed world, causing significant distortions in global currency markets. While China has been artificially moderating the strength of its Renminbi to counter these imbalances, Brazil's Real is surging. Concerns are growing that this could break out into an all out currency war; countries like Brazil are becoming increasingly vocal about their displeasure. An obvious side effect has been a surge in commodity prices; its inflationary effects are now being imported into developed economies.
Inflation
What concerns me is that inflation could snap back violently. Alarmingly, many investors are simply not prepared for such an event. Liquidity is thinner in most financial markets, whether because of the Dodd Frank Act or because banks are reining in their finances as the economic outlook deteriorates. Careful security selection within financials is paramount and investors should concentrate on the best issuers and in a part of the capital structure that should not be negatively impacted by any future recapitalisation needs.
In Europe, it's clear that market sentiment in the ‘core' remains negative. The current political action and response from financial institutions has been seen as inadequate. Yet the ECB has done what it can to bring to stability to European bond markets. In total, it has purchased around €36 billion of sovereign bonds, helping to pin down yields on 10-year Spanish and Italian sovereign debt to the 5.0% level. These purchases have been highly visible - the ECB has been actively buying sovereign bonds on a daily basis. Unlike with previous purchases from Greece, Ireland and Portugal, the ECB has not placed conditions on Italy or Spain. The event has also been a sterilised operation, meaning the ECB is not funding purchases by creating more euros.
Some investors would have liked the ECB to have done more, although I believe it has done everything it can to stabilise markets. It is important to note that there are also long-term plans. Talks are already underway to extend the powers of the current European Financial Stability Fund (EFSF); this is a special purpose vehicle set up to preserve financial security in the eurozone. It has previously been used to help fund bailouts in the ‘periphery' by issuing triple-A rated bonds, seen by some as the first move toward fiscal consolidation.
Yet there has clearly been disappointment from those who expected the ECB to explicitly announce a pan-European bond program. Personally, I think this would have been a mistake. The problem with a centralised bond program is that it ignores the differences in economic structure between states and doesn't address the current fiscal imbalances. We could end up with a situation where borrowing costs are raised in the ‘core', whilst the ‘periphery' benefits from cheaper financing. The fiscal problems in the eurozone need to be addressed first.
Uncertainty has seen investors flee to the safe havens of high quality sovereigns and precious metals. In Europe, while the periphery may have performed badly, the ‘core' has delivered strength. In terms of credit, financials may have underperformed, but this has been offset by strength in other corporate sectors. And, as the high yield market gets beaten up, nimble fund managers can find attractive opportunities.
Asset allocation
Asset allocation is an increasingly important part of fixed income investing in a two speed global economy. The diversity gained by having the access and liquidity afforded by the US treasury market, despite a recent downgrade by Standard and Poor's is tremendous. The US is still the largest and most liquid bond market in the world. Asian bond markets offer fantastic opportunities - GDP growth in Asia is far higher than the US or Europe. Asian credit and sovereign bond fundamentals look good right now, so it makes sense for investors to diversify into this region. Although slowing growth, sovereign risks and currency imbalances might concern investors, they can still benefit from remaining diversified and making careful credit selection decisions.
Going forward, investors should look carefully at the benchmarks that their managers use as the starting point of their investment process - the idea of a ‘risk free asset' has been dethroned. Investors should be particularly wary of excessive exposures to governments and financial companies with poor or deteriorating finances.
Current global benchmark construction means that the increased funding needs of these institutions could dominate portfolio risk. The old adage seems to stand up well today, ‘Only lend money to those that don't need to borrow'. Investors should look for bond managers who use thorough fundamental research to generate diversified sources of investment return; a multi-strategy approach like this means that no single position is allowed to dominate overall risk
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