German companies are looking to hire at record levels and Italy’s finances seem better than predicted, but Barclays thinks inflationary pressures will continue to be a major concern in the developing world. More than 70% of fourth-quarter earnings reports exceeded analysts’ estimates, providing a healthy backdrop for U.S. corporate bonds.
Bob Doll, Black Rock, Chief Equity Strategist
Equities finished 2010 in a position of significant strength thanks in part to improved economic expectations, improving jobs growth news, and the capital markets-friendly combination of QE2 and Congressional passage of the Bush tax cuts with some fiscal sweeteners. In this context, with risks to the downside reduced, we believe there are opportunities for investors in risk assets, and in stocks in particular.
With the strong fourth quarter of stock market gains behind us, investors will be assessing whether the upswing will continue. The strong technical backdrop of the likely shift of investor flows into equities, the probability of continuing strong corporate earnings, and our belief that the unemployment rate could begin to notch down contribute to our positive view. However, downside risk does exist in the continued weak housing market, the potential for negative state and municipal credit events, and impacts from European crisis and emerging markets rate tightening.
Strong balance sheets and income statements with healthy free cash flow will likely lead to considerable increases in dividends, share buybacks, merger and acquisition (M&A) activity and business reinvestment. In this context, we see higher quality economic growth (more from demand, less from stimulus) and resultant higher gross domestic product (GDP). Combined with improved business and consumer confidence and a less hostile capital markets attitude from Washington, DC, we are forecasting another reasonably good year for risk assets.
With the improved economic outlook and strong corporate earnings and likelihood for improving flows into equities, investors should consider incorporating both high quality and cyclical opportunities into their portfolios. While there continues to be downside potential, we believe the upside possibilities outweigh the downside risks.
From a sector perspective, telecommunications remains a favorite, while energy and industrials also have become more compelling. Healthcare continues to show promise, but we believe consumer discretionary may end its significant outperformance. Our outlook for financials continues to show headwinds and we believe the fundamentals of consumer staples have declined to neutral.
Peter Fisher, Black Rock, Global Head of Fixed Income
With economic growth expectations shifting upward, we believe investors should begin to review portfolio allocations. While economic indicators continue to demonstrate mixed messages such as an improvement in consumer and manufacturing sectors against an increase in unemployment and continued decline in housing, we believe an economic environment of low domestic inflation and slow-to-moderate growth will prevail. Against this backdrop, investors will continue to be challenged to balance the tailwinds of moderately improving economic expectations with the structural headwinds to US labor market growth, which is crucial to economic recovery.
We believe inflation will remain a non-issue as the late fourth quarter US Treasury rate backup was, we believe, a result of a rebound from overbought conditions and a response to European economic issues as well as improving US economic conditions. In this context, and with a complex global environment of European crises, emerging market rate tightening and US recovery dynamics, being nimble in sector selection and duration will be critical. We continue to see opportunities in high yield as growth improves and rates are held low. We also see agency mortgages and securitized sectors as attractively priced given the recent backup in rates.
Taxable Fixed Income Views
We believe there are encouraging signs that QE2 and extension of Bush-era tax cuts have aided the recovery meaningfully and raised economic growth expectations.
With positive supply/demand dynamics for fixed income assets, we continue to favor higher-quality spread sectors but have also begun to see opportunities in agency mortgages.
Municipal Markets Outlook
While state and local governments have clearly been hard hit by the fiscal challenges and the expiration of the Build America Bond program, we believe munis still offer attractive relative yield and some degree of capital appreciation potential. We believe there is a substantial margin of safety between credit deterioration and potential insolvency and believe that states and localities will continue to make timely and full payments on their general obligation debt. While a decline in direct federal aid is a threat, the improvements in revenue collections and exercise of powers to balance budgets and restore fiscal integrity bode well for future health. We believe the fourth quarter technical conditions of significant mutual fund outflows amplified an already weak seasonal period for munis marked by increased supply, and that the first quarter brings a more constructive outlook.
Municipal Markets Views
We continue to favor state tax-backed and essential service bonds, particularly the Southwest, Plains and Southeast regions. We also like dedicated-tax bonds and housing issues.
We continue to have a less favorable view toward land-secured bonds, senior living bonds, bond insurers, student loans, pre-refunded bonds and local tax-backed issues.
Julian Callow, Barclays Capital, Global Economics Weekly
Central banks head into 2011 with resurgent equity and commodity prices providing another reminder that monetary policy, including quantitative easing, is still effective.
Encouraged by anticipation and then reality of the Fed’s second wave of asset purchases, commodity indices have risen sharply, with some (such as the CRB spot index) hitting record highs, while some equity markets have recovered back to pre-September 2008 levels.
Global business confidence has also staged an improvement since September, thereby negating the fears that had emerged last summer of a potential double-dip, although within the improvement are some varying trends. In particular, while the US and euro area activity and new orders data have improved quite significantly in recent months (including for Italy and Spain), in China and India confidence has ebbed slightly with recent readings, while the Japan PMI has remained below 50 (that said, we are now more positive about Japanese GDP expansion in CY11 Q1 following indications of further strength in industrial production from the MITI survey).
Overall, the global economic expansion appears to be still on track, with a remarkable degree of resilience apparent across much of the euro area manufacturing sector (particularly Germany, which is recording near-record hiring intentions), as well as positive signals from US consumption (where our tracking estimate signals some upside risks for our Q4 estimates). Meanwhile, in countries facing extreme fiscal tightening (such as the euro area periphery and UK), service sector confidence has (unsurprisingly) been moderating.
The surge in commodity prices is leading investors to question how long the current highly stimulatory global monetary policy can last. This is a particular concern to emerging economies, which tend to have larger weights for food in CPI baskets, and this is especially true for India, China, Brazil and Mexico. With various special factors, including adverse weather and the relatively early timing of the Chinese New Year, set also to contribute to yet higher food prices in the near term, it is likely that governments in many emerging economies will need to do more.
Largely incorporating the impact of stronger energy prices, as well as certain localized factors, we have made some upward revisions to our near-term CPI projections. Our euro area projection envisages the HICP rate reaching a peak of 2.5% in February and 2.3% for this year, suggesting that the ECB is likely to make a sizeable upward revision to its inflation projection in the months ahead (its December projection had been a mid-point of 1.8% for 2011). We expect UK CPI inflation to hit 4.1% in February (and the RPI rate to be at 5.2% in January and February), with the CPI more than twice the target rate. We have also raised our US CPI projection for 2011 by 0.2pp (to 1.8%), and our Japan CPI forecast from -0.3% to -0.1%. Our forecasts for the Philippines, Indonesia and Colombia have also been raised.
Another way in which commodity prices can influence inflation is via production costs. The relative sensitivity of manufactured goods to commodity price swings may be greater than sometimes perceived, given the switch in production to low labour cost zones alongside much stronger industrial raw materials prices. For example, the Chinese series for clothing producer inflation rose to 2.7% in November, the strongest since the July 2000 spike. This could become apparent in CPIs in the advanced economies (indeed, this is already happening in parts of Europe).
That said, policymakers’ responses to these global developments are likely to be varied. Most emerging economies face stronger inflation pressures not least because of their rapid growth in the past few years. However, for them monetary policy is likely to be regarded as only one of several options to curb inflation pressures. In China and India administrative measures are being sought, while changes to reserve requirements and administrative guidance to banks are other options (while, after the December 25 rate hike, we look for China to undertake a further two quarter point increases in Q1 and Q2). Some central banks may also permit FX appreciation to dampen inflation pressures, as is being adopted by Korea and Taiwan (which are particularly susceptible to Chinese export prices). However, it is difficult to generalise. Brazil continues to undertake measures to dampen FX appreciation (the latest being measures to limit short dollar positions by the banking system).
From the US monetary perspective, the outlook continues to be focused strongly around the outlook for unemployment and for core inflation. The former just declined to 9.4% but remains troublingly high, while the latter has so far been subdued, and inflation expectations are not at troublesome rates. Currently we do not expect that the surge in commodity prices is sufficient to generate downside risks to our private consumption forecasts, though this will be a point to watch if it continues. Hence we do not currently foresee that the rise in commodity prices will be sufficient to result in a shift in the Fed’s stance. Indeed, the recently published minutes to the December FOMC indicated the determination of the committee to proceed with its asset purchase programme, and we cannot still exclude a further extension of this beyond June.
For European central banks the focus is likely to be on inflation expectations, within the context of substantial macroeconomic uncertainty (generated in particular by the sharp fiscal tightening in the UK and periphery). From the euro area perspective, the historical influence that appeared to run from commodity prices into core inflation appears to have dampened in the past five years, as price setting has become more flexible and as inflation expectations have become more significant and stable. Also, inflation in many countries is being pushed higher by indirect tax measures. Overall, in the context of these factors, we do not expect that the likely run-up in CPI inflation rates in the next few months in Europe will generate a significant near-term shift in monetary policy. However, it is likely to provoke renewed inflation-fighting rhetoric from policymakers. From the markets’ perspective, this could be a wake-up call that high accommodative monetary stances are not sustainable in the longer term.
Laurence Boone, Barclays Capital, Outlook: Euro Area
The first quarter of the year is traditionally an important quarter for sovereign issuance. This time will be crucial in the euro area where total sovereign issuance should amount to €865bn, in a spread widening environment. During the holidays spreads widened for Greece and Ireland in the 5y and 10y maturities by 90bp and 70bp, respectively, for Portugal by 50bp and 30bp for the same maturities, but little for Spain. We look for the fiscal adjustment process to continue, and to be supported by an ongoing recovery. That said, large spreads may become more difficult to handle for Portugal, while we are more confident Spain is in a better position to adjust its public finances. As mounting inflation may threaten the accommodative stance of monetary policy, which would toughen the task of adjusting countries, the market will look for the completion of the euro permanent rescue mechanism over the next quarter.
According to euro area government plans, fiscal adjustment is set to toughen this year, with more countries exhibiting fiscal restraint in line with the periphery countries. We expect fiscal adjustment to amount to 1.2pp of GDP for the euro area as a whole, with structural adjustment reaching 4.3pp of GDP in Portugal, 4.0 in Greece (after 7.0pp in 2010) and 2.6 in Spain. Overall, on our estimates, the euro area deficit-to-GDP ratio should narrow to 4.6% of GDP in 2011 down from 6.3% in 2010 (UK: 8.3% in 2011 after 9.7% in 2010; US: 8.8% of GDP after 10.0% in 2010), but the debt ratio will reach 86% of GDP, up 2 points on 2010 (UK 2011: 82% and US: 84%).
In addition, some countries have shown improvements in their general government deficits beyond projections that were made for 2010. For example, recent figures on tax collection and local spending in Italy showed an unexpected improvement in the autumn of 2010 that suggests the deficit-to-GDP ratio could be below the 5% originally planned. As well, PM Zapatero said on a radio interview on Tuesday 4 January that Spain’s general government deficit could be somewhat below the official 9.3% of GDP target in 2010 (BarCap: 9.1%). These are encouraging signs for pursuing adjustment in the years ahead in the periphery.
Looking ahead, the 2011 fiscal adjustment is likely to be a bit more challenging, although ongoing global recovery should provide support. Indeed, the manufacturing PMI published this week continue to suggest a dynamic recovery in the manufacturing sector, while PMI in the services sector show a more divergent picture: confidence remains strong in Germany and France, but has weakened in Italy, Spain and Ireland. This contrast is perhaps not such a surprise, since the manufacturing sector will tend to reflect global trends and exhibit greater integration across economies, whereas service sector trends are more likely to be influenced by national-level trends (such as the worsening financial market tensions during Q4 and growing awareness of the scale of the impending fiscal tightening). In this respect inflationary pressure is unwelcome as it could erode households’ purchasing power.
The euro area ‘flash’ estimate came in at 2.2% y/y in December, up from 1.9% in November, possibly reflecting rising food and energy prices. Indeed, energy prices rose to 10.2% y/y from 7.9% y/y, with petrol prices climbing to 13.9% y/y from 10.3%, heating oil prices rising to 25% y/y (from 18.7% y/y), and gas prices to 8.3% y/y from 7.5% y/y. We had changed our inflation forecast upwards in the last few weeks, on higher commodity prices and potential tax rises. We now look for euro inflation to be 2.3% this year, with the peak at 2.5% in February.
Increasing divergence in performance across euro area and rising inflation will make the task of deciding monetary policy more complicated, as the ECB looks to strike the right balance between low interest rates needed for the peripheral countries and the need of high interest rates for some core countries in view of rising prices. Indeed Reuters reported this week that Yves Mersch, Luxembourg’s representative on the ECB’s governing council, already warned of the need for government to end their stimulus policies. In this respect, the ECB meeting due on 13 January could discuss its assessment of possible second-round effects in some countries: although we do not think that second-rounds effect could spread at this stage of the recovery, they could materialize in some core countries in the future..
Euro sovereign issues will proceed at a robust pace across Q1. The Portuguese, EC and French auctions took place this week without any issues. The next important auction is Spain next week. As euro sovereign issuances proceed across the first quarter of the year, the evolution of spread will be closely followed. In previous research, we have argued that if Portugal is borrowing at an interest rate of 6% or more, it will struggle to attain fiscal solvency; Spain is in a better position, we think, given a healthier initial situation and as a significant part of its deficit is due to ad hoc support.
Key dates will be the Ecofin meeting on 18 January (preceded by the eurogroup meeting on 17), and the Council of Head of States meeting on 11 March. In our view, we should get some precision on the permanent crisis resolution mechanism for the euro area (due to come into effect by mid-2013), including the possible implementation of collective action clauses and private sector burden-sharing. These precisions will be eagerly awaited by the market, in our view. As well, new stress tests will take place in H1 11: their impact could be more significant as they will be monitored by a European authority with investigative powers, which was not the case in 2010.
Michael Gavin and Alanna Gregory, Barclays, Emerging Markets Weekly
Runaway inflation is not likely, except as a risk in a very few countries with less disciplined economic policy frameworks than have become the emerging market norm. But recent data flow, policy actions, and market reactions suggest that higher inflation will be an important market driver in the months to come.
This sets the stage for a risky period for local bond markets, and it is not clear to us that markets are compensating investors for those risks. Barring a major monetary policy mistake, equities should benefit from strong recoveries more than they are hurt by tighter monetary conditions. External (USD) debt is an unexciting but relatively safe place to wait for now, since a disruptive inflation event seems like a very remote risk for the United States. In FX, the challenge for investors will be to distinguish those monetary authorities that will focus on controlling inflation from those that allow themselves to be distracted by ‘currency wars’.
With only about a week of post-holiday news flow and trading under our belt, it would be reckless to extrapolate recent developments into the remainder of the year. But we cannot help ourselves, since it does seem to us that a number of themes that have emerged in the post-holiday period will be with us for some considerable time to come.
Global markets have been supported by the good type of ‘flation, that is, the continued evidence for ‘reflation’ of the global economy that has underpinned our generally bullish perspective on risk asset markets, including emerging markets. Most of this evidence has come from the US, but doubts about the sustainability of the US recovery have been a source of much hesitancy among global investors in past months.
But the global recovery has contributed in a number of ways to the other kind of ‘flation. Inflation and the required policy response has been an important theme and market driver. We suspect it will remain so in the rest of the year.
While the risk of 1980s-style inflation remains very limited almost everywhere (with isolated exceptions such as Argentina and Venezuela), more and more of the emerging world is now actively engaged in an attempt to cool inflationary pressures, while in others, it is only a matter of time before economies emerge from the monetary policy ‘sweet spot’ in which rapid growth co-exists with subdued inflationary pressures. Brazil’s inflationary rebound is, of course, old news. But we also think that the long, recession-induced decline in Mexico’s core inflation is pretty much over, at a level that lies within Banxico’s tolerance band, but materially above the 3% inflation target, offering scant cushion for inflationary surprises down the road.
China’s shift toward a less accommodative, anti-inflationary monetary stance is also old news, though the recent rise in energy prices is making the problem look somewhat more stubborn than might earlier have seemed the case; November’s 5.1% inflation print would appear to pose some upside risk to our 2011 inflation forecast, and while non-food inflation remains low, it has recently been rising. We also see increasing evidence that China’s wage and export-price inflation is affecting inflation elsewhere in Asia, where, in addition, higher energy prices pose upside risks that may be harder to shrug off than the run-up in food prices, both because energy commodity prices tend to be more persistent and less ‘spiky’ than food prices and because higher energy prices feed through to such a broad range of commodities. And it is not just commodity prices; while Indonesia’s 7% 2010 inflation rate is attributable mainly to food, core inflation has been rising and we expect it to reach 5% within the first half of the year, forcing a monetary policy response, despite the central bank’s wish to avoid additional capital inflows.
Even in EMEA, we are beginning to see evidence of developing inflationary pressures in Poland, Russia and the Czech Republic that may require a monetary policy response sooner rather than later.
We repeat, we do not think that we are going to see an explosive inflationary event; not in 2011, and not in the foreseeable future. 2011 does not even look like 2008, because unlike then, most of the advanced economies are very far from overheated and will likely remain so for some considerable time. However, the combination of continued upward pressure on commodity prices, now affecting the energy complex as well as agriculture, inter-country transmission of wage inflation from high-pressure economies (specifically, China) created by the inter-connectedness of global production chains, and central banks that are under pressure in many cases to subordinate normal monetary policy objectives to the goal of maintaining currency competitiveness adds up to an environment in which inflationary pressures and the policy responses to them will be a major driver of markets.
Generally speaking, of course, local bond markets are at most risk in this environment. And while we like some bond markets outright (such as South Africa’s), in many others it appears to us that investors are not offered much compensation for the risks. External debt has outperformed local in the (admittedly very short) year to date, and it would not be tremendously surprising for this to continue while the EM inflationary drama plays out, at least if local market returns are measured on a currency-hedged basis.
The more interesting questions lie, it seems to us, in EM FX, as illustrated by the radically different performance of the CLP and EUR/PLN in the past weeks, as well as the less dramatic but still positive performance of EM Asian currencies in the post-holiday period.
On the one hand, EUR/PLN highlights the upside in owning a currency whose central bank is well ahead of the inflationary curve and that can live with a stronger currency as part of a tighter, anti-inflationary monetary policy stance. The CLP illustrates the risk of finding out that the monetary authority is less focused on orthodox objectives and more hostile to currency appreciation than one would have thought.
We remain of the view that EM Asian currencies offer the most interesting upside in the increasingly reflationary and inflationary environment. There are currencies where valuations are not particularly stretched, whose countries’ external accounts robust, and the policy authorities’ incentive to tighten in response to growing inflationary pressures is likely to increase over the course of the year.
Prudential Fixed Income First Quarter 2011 Outlook
The bond market had another good year in 2010. Despite the ongoing European crisis and 4Q US Treasury sell-off, most fixed income sectors delivered solid total returns for the year, ranging from +5.9% for US Treasuries to +15.1% for high yield bonds.
US Growth Outlook: From Moribund to More Positive
Until mid-4Q, the fixed income markets had enjoyed a nice six-month rally amid signs of sluggish US economic growth and the ongoing sovereign crisis in Europe. In 3Q, Fed officials hinted at further monetary accommodation, voicing their dissatisfaction with the rate of US economic growth and uncomfortably low level of inflation.
Ultimately, the Fed initiated a second large scale asset purchase program (the so-called “QE2”), whereby the Fed will purchase $600 billion of US Treasuries through June 2011. Although intended to lower interest rates, spur economic growth, and boost asset prices, enthusiasm for the highly telegraphed “QE2” buy program had already, similar to “QE1”, driven long-term interest rates to their lows before the program was formally announced.
Buy the Rumor, Sell the News
No sooner was the program announced than US economic growth data began to improve. To boot, the extension of the Bush tax cuts, which included additional fiscal stimulus via payroll tax cuts and investment incentives, only added to growth expectations. All said, this much improved economic growth picture pushed US Treasury rates sharply higher in the final weeks of 2010. Spooked by the backup in yields, mutual fund investors pulled money out of bond funds for the first time in two years exacerbating the sell-off.
The Pain Game in Europe
Troubles in Europe continued in 4Q with mounting losses in the banking sector ultimately necessitating a bailout for Ireland in late November. While the package has served to temporarily control the liquidity crisis, spreads on the sovereign debt of the beleaguered European peripheral countries remain wide, with investors not convinced that additional restructurings will ultimately be avoided.
Despite ongoing tensions, economic growth in core Europe has continued unabated. As a result, investors were less concerned about contagion from the Irish crisis than they were during the Greek crisis last spring.
Spillover From European Crisis Less Severe in 4Q
Where Does This Leave Us for 2011?
While a close call, we believe the recent sell-off in US Treasuries may be overdone, especially for longer-term bonds. Despite signs of improving economic growth, several factors - most notably high unemployment and low inflation - should conspire to keep yields low. These structural issues are likely to be with us for some time; even the Fed’s recent forecasts don’t project core inflation to reach 2% or unemployment to drop below 7% before 2013. The fact that the Fed will absorb virtually all net US Treasury supply for the next six months via their asset purchase program should also keep yields on the low side.
As for the spread sectors, low net issuance and healthy fundamentals provide a positive backdrop. Arguably, the ongoing European crisis kept spreads from tightening commensurately as quality improved in 2010. As a result, the prospects for incremental yield and potential price appreciation from most spread sectors remain strong. Like 2010, however, fluctuating growth expectations, housing woes, concerns about a burgeoning US budget deficit, and potential flare-ups in Europe are likely to surface in 2011, creating some speed bumps. All said, we look for investors’ reach for incremental yield and contracting spreads to drive respectable absolute and relative returns in many, if not most, fixed income sectors in the coming year.
Investment grade corporate bonds performed well in 2010, delivering +229 bps in excess return over US Treasuries and an absolute total return of +9.0%. US corporate spreads tightened 16 bps for the year, closing at +156 bps over US Treasuries. In the European corporate market, which suffered due to sovereign concerns, spreads widened 37 bps over mid-swaps but still posted a positive total return of +4.8% for the year.
As in prior quarters, corporate bonds benefited from improving credit fundamentals and positive earnings growth. In fact, more than 70% of earnings reports released in 4Q exceeded analysts’ estimates. Ongoing government stimulus efforts, strong investor demand, and a well-subscribed new issue market also helped.
For the year, BBB-rated issues and companies in cyclical industries such as chemicals, metals, and paper performed best while defensive industries such as supermarkets, healthcare, and aerospace lagged. In Europe, peripheral sovereign-correlated sectors, such as utilities and telecommunications, underperformed as sovereign risk continued to override credit strength.
As we enter 2011, we believe corporate bonds still look attractive at today’s spread levels. We favor select financial companies given their wide spread levels and deleveraging balance sheets. We look for sentiment to gradually shift in favor of financials as the economy recovers and mergers and acquisition (M&A) activity increases in the industrial sector.
Currently, we are focused on money center banks, insurance companies, and other independent financial institutions. We are also finding value in cyclical industries such as chemicals, metals, and airline enhanced equipment trust certificates, as well as in well-researched BBB-rated issues with stable credit metrics and attractive spreads. Longer-term corporate bonds also look attractive, given the recent rise in interest rates. We are selectively investing in Build America Bonds (BABs), favoring revenue bonds such as toll roads and essential services. We remain underweight European financials and, in global corporate portfolios, are overweight US versus European credit.
We are keeping a close eye on increasing event risk in light of record high corporate cash levels. Ongoing sovereign risk and a lack of cohesive policy and action from European institutions and governments could also setback the market.
Outlook: Positive. Strong credit fundamentals, improving economic outlook, and “reach for yield” environment should drive spreads tighter.
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