Institutional investors should watch key markets for signs of global recovery
Institutional investors began 2013 with the anticipation of a gradual global economic recovery. While this trend may play out, there is a need for continued caution as diminished interventions by central banks and political challenges in several major economies could play a disruptive role.
The financial situation in Europe has remained generally calm since European Central Bank president Mario Draghi indicated last summer that he was prepared to do “whatever it takes” to preserve the euro. Much of the calm that has permeated the markets since then has been driven by central bank rhetoric— perhaps a shaky foundation for a sustained market recovery across Europe. Yet a central bank that is prepared to backstop government bonds and continue providing liquidity to the banking system is something the markets will test only reluctantly at this stage.
There have been some “real” improvements in Europe. Large external imbalances have begun to right themselves, eliminating the need to fund a large current account deficit, while there have been some structural reforms undertaken. Fiscal austerity will remain with continued headwind to economic recovery. And while political tensions will remain as spending cuts and tax hikes continue, these adjustments are helping to reduce budget deficits.
But investors should not be complacent. Growth is sorely lacking across much of some of the Nordic countries and Germany, the economic fundamentals in many European countries are weakening. This situation is especially acute in France, where growth disappoints and the public finances are stretched. The U.K. is another market that has come under pressure, with the focus increasing on its weak public finances, poor growth outlook and a rising current account deficit.
Structural reform continues in Europe, but it will take time to bear results, and indebtedness across the region remains significant. The waters may be calmer, but it would be foolhardy to say the crisis is over. Watch the politics closely— February’s Italian elections, the Cyprus financial bailout package announced in March and the fall German elections could all shift the tides.
Across the world, the Bank of Japan may be the next central bank to embark on a monetary experiment of major balance sheet expansion in a bid to end its deflationary economy. While it appears that the near-term phase of yen weakening may have run its course, further depreciation may occur following changes to key Bank of Japan board members (including the governor) in April.
A weaker yen makes general sense for the Japanese economy. However, a further rapid weakening of the yen would likely prompt interventionist action from Asian central banks concerned that a more competitive yen might undermine their own economic recovery. Investors who are generally constructive on Asian currencies this year should keep a close watch on yen policy.
This view of the world in 2013 lends itself to taking a more underweight position in many of the core duration government bond markets and a tactical approach to investing in some of the higher-yielding government markets. A deepening crisis would spell renewed volatility and a potential return to some of the better “safe haven” assets such as German bunds, U.S. treasuries and Canadian government bonds. However, there appears to be several structural reasons for bonds to remain a well-supported asset class over the medium term. Higher nominal yields on the back of stronger growth may also be accompanied by higher break-evens on inflation-linked instruments.
Fact File
Nick Eisinger is a global sovereign research and strategy analyst with Fidelity Investments. nick.eisinger@fmr.com
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