Friday, November 30, 2012

Low systemic risks & low nominal growth

I have published a short presentation "Low systemic risks & low nominal growth". This is a brief update to my strategy presentation from August "Life in a negative real yield environment".
There are three key points I want to make which I think so far have gone underrepresented:
1. Inflation pressures in the Eurozone are highly overstated. I adjust the Eurozone inflation figures for the effects of restrictive fiscal policy (via higher prices for administered goods and higher taxes on consumer goods). This adjusted core measure runs only at around 0.5% yoy! Hence inflation for the private domestic economy is almost non-existing. I think this is so far not really recognized but should come as no surprise given the high level of unused capacity/record high unemployment and the subdued development of monetary aggregates and loan growth (loans to non-financial corporates have been falling by 1.8% in October yoy). As "true" inflation is lower, "true" real yields are somewhat higher than those traded in the market (which also focus on HICP) and hence the safety premia inherent in Bunds is lower. I do expect Bund yields to rise over the medium term as real growth improves and the stress in peripheral bond markets eases, however, nominal growth will remain subdued and hence upward potential for 10y Bunds is limited (I expect 1.75% 6m).
2. Markets have shifted their trading behaviour. Ever since the financial crisis broke out, RORO (risk-on, risk-off) dominated market developments. Equities, credit spreads, volatility, commodities, growth currencies have all moved in sync and opposite to safe-haven assets (Bunds, UST, JPY, USD). RORO was dominated by changing perceptions of systemic risks (which then drove also the expectations for growth and inflation). Now, however, systemic risks have been dropping significantly (as the ECB has turned itself into the lender-of-last resort for sovereigns) and RORO has given way to GOGO (growth-on vs. growth-off). In this environment it is changes for nominal growth which drives market performance while systemic risks remain low. In turn, equities, commodities and growth currencies move in sync while credit spreads and volatility remain low even during periods where the other markets correct.
3. In an environment of limited volatility and anchored short end rates (as central bank target rates remain unchanged), so-called Horizon Returns gain in importance as a tool to direct investment/as a relative value tool. It is not only carry that is important but also roll-down on the yield curves. Horizon Returns measure both.
My investment views remain unchanged: Systemic risks remain low favouring carry products. The long-term trend towards lower nominal yields on safe products is over (i.e. Bund yields most likely have hit bottom) but upside potential on safe yields is moderate in the short term. The long-term trend towards lower nominal yields on carry products is not over (and hence semi-core/peripheral bonds have more potential). The global growth cycle should have bottomed with Asia ex Japan improving and the slow improvement of the US economy only being temporarily interrupted by the fiscal cliff. Growth currencies should be bought and safe-haven currencies should be sold on uptics (with the Euro being between these two groups).

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