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Notes from the Fixed Income Trenches: Living in Wonderland?

Mike Temple
calender-icon Posted on June 26, 2012

I sometimes feel like I’m living in Lewis Carol’s world of “Alice in Wonderland.”  Only in this financial “Wonderland,” bad is good and good is bad, safe haven assets (despite deteriorating fundamentals) are prized above all else and the truly cheap stuff (emerging market equities, anybody?) are swept into the dust bin. It causes one to wonder if the markets will ever escape back up the rabbit hole.

But we must drink the potion we’re given, so to speak, and many investors now find themselves in the uncomfortable position of cheering for more capital market pain and more signs of deteriorating economic results in Europe, the U.S. and the developing markets so that policy makers will respond with the desired monetary accommodation. As a result, so called risk assets – equities, high yield and commodities – are selling off, but not convincingly, since the lower they drop, the more likely a policy response will send them skyward. So both the “longs” and “shorts” are nervous.

So What Breaks this Pattern? 

The market is clearly waiting for something big from Europe.  As my colleague Paresh Upadhyaya expressed so well in his latest blog, no one expected the Fed this time to launch QE3 (a bigger, more luxurious vessel than QE2). Simply put, if the U.S. is not the problem, it can’t be the solution. 

It is time now for the EU to make a choice – move more rapidly toward fiscal and political integration, supported by a program to mutualize sovereign debt, or (through inaction) let the grand monetary experiment die. Accelerating the flight of capital from peripheral banking systems is a quickening fuse.

I won’t get into the debate about which course of action makes the most sense in the long term (but for a more in-depth discussion on the subject, please see our recent Global CIO Letter).  There are plenty of pundits lined up on both sides of the argument. Last week there were tentative signs that Germany’s hard line toward austerity first and integration and debt mutualization later, was beginning to crumble as the German economic powerhouse feels the pain of the recessions experienced by the peripheral countries. Remember – what’s bad is good…

The Next Twists and Turns 

Next week’s Euro Summit may offer a critical turning point. Investors will be straining for some positive news as “leaks” enter the blogosphere from a meeting prior to the summit between German Chancellor Angela Merkel, Italian Prime Minister Mario Monti, Spanish Prime Minister Mariano Rajoy and French President Francois Hollande. Of course, the market is likely building up too high an expectation of a “master plan.”

So we think a plan – even a tentative one – that diagrams a comprehensive framework for integration and debt mutualization needs to be floated for risk markets to hold steady. Some of the critical elements of such a plan could be the final details of a Spanish bank recapitalization and a Sovereign bailout that would further help insulate Spain from contagion and provide the foundation for the ring-fencing of Italy. However, without a clear plan, the ECB needs to be prepared for monetization to buy European leaders more time to hammer something out.

What is a Fixed Income Investor to Do?

As this trip through Wonderland continues, many investors are choosing to sit on the sidelines, begrudgingly enjoying the safety of cash. For many, return of capital today trumps return on capital. But in a world of +2% inflation, a cash return of zero means a loss of capital – just more slowly…

Others are choosing to hide out in U.S. Treasuries, and it’s hard to argue against the returns of longer-dated Treasuries over the past 30 years.  But as we point out in our recent paper “The Tug-of-War between Deflation and Inflation,” that game is getting increasingly dangerous. Yes, all good things must come to an end.

Credit has clearly become the middle ground for most investors: high yield as “the less volatile equity,” or investment grade and municipals as “Treasuries with spread.” Our philosophy has been pretty straightforward. The fundamentals and income generating capability of credit continue to offer the best risk/return trade off in fixed income. But diversification and the ability to exploit dislocations in a world fraught with volatility and high correlations remain critically important.

We think it makes sense to be cautious.  But, like the “shorts,” we remain nervous about missing the upside, so the key for us has been to construct portfolios that can provide income and remain poised to take advantage of a potential European solution. Should a credible plan be floated, Alice (the market) should escape back out of the rabbit hole.


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