SCOREBOARD: Year of the bond sell-off

The year ahead looks likely to bring a mammoth bond sell-off and decent equity and commodity rallies, but investors face inflation and volatility risks.

The year 2011 was without doubt one of the strangest years I have ever seen and it was obviously a very difficult year to make money. Fear dominated everything. Consequently, the widespread view that market moves were random is one I generally agree with and certainly headlines through the year were incredible. It’s hard to believe that through it all, actual growth outcomes (global and domestic) weren’t too bad. There were some instances where growth was weak, others where growth was the strongest in years. This is not unusual in a diverse global economy and we shouldn’t expect outcomes to be uniform. Overall though, the global economy did well, and that’s with the temporary disaster-induced distortions that we saw, not to mention the political antics in the US and Europe.

With that as our backdrop, market moves have been especially interesting – and extraordinarily humbling. Unfortunately, and unlike 2009 and 2010, being on the right side of the economic debate simply hasn’t made any money this year. Think of the global bond rally. Decent growth, sharply accelerating inflation and yet yields on treasuries, bunds, gilts and even our own ACGBs are at or around record lows. On the other side, ‘club med’ spreads are around euro-era highs. Debt with any perceived risk attached to it is given a wide berth, which has even seen a wide spread develop between Australian state debt (even that carrying a Commonwealth guarantee) and Commonwealth bonds. Liquidity might be an issue in some cases, but still. Elsewhere, equities were generally weaker (flat in the US, down about 15 per cent in Europe and Australia), and commodities generally took a hit as well. All the while the global economy grew and extraordinary amounts of cash were pumped into the system.

Would you punt on the global bond rally, or this price action more generally, continuing through 2012? It’s a difficult call, but I’d have to say no, overall. There are a number of complicating cross-currents to consider though.

Just on my macro view, we should see the mother of all sell-offs for bonds this year and a fairly decent equity and commodity rally. So I expect no real change to underlying global growth momentum. Growth will likely be in the vicinity of 3.75 per cent to 4.75 per cent and I suspect inflation will remain sticky in the first half of 2012 before accelerating in the second half. The way I see it and despite the debate, underlying momentum didn’t really change much through the year. Don’t get me wrong, I’m not saying it didn’t change at all – point forecasts are certainly lower and may be lowered further again. But I’m not too bothered by the point forecasts at this stage. I think it’s immaterial in this binary world and given market pricing. Markets are positioned for disaster at the moment. So the world is either going to implode, or it’s not.

My broader point is that all the factors that have supported growth over the last 18 months to two years remain unchanged. Exceptionally stimulatory monetary policy, pristine corporate balance sheets and households that are in a much better position to engage in sustained consumption (which is why we are seeing US consumers rebound). Most governments will continue down the path of austerity, sure, but that’s not a recipe for a recession in most economies. It’s just the difference between growth at 3 per cent or 5 per cent – or whatever (2 per cent or 4 per cent). Otherwise the private sector more generally looks good and some governments are even talking about providing more stimulus.

On that basis I’m not looking for a sustained drop in inflation through the year. I think the recent downturn in some commodity prices will likely see a temporary slippage in inflation, but it will prove temporary given exceptionally low interest rates, robust global growth and considering the enormous amount of cash in the system. Commodity prices will likely rebound this year, and given the other inflating factors, I suspect inflation will remain a problem.

Then there is the fear, or sentiment. The million dollar question is whether the fear we saw through 2011 will continue unabated this year. Remember this is only constraining factor that prevents the vast tsunami of cash that is available (or potential cash) being put to work. It’s not weak growth – no double dips. It’s not an actual European implosion. The euro still exists. It is fear – we spent most of 2011 afraid of things that didn’t happen and probably won’t. So how much of that fear will remain? Well, I’m not a psychologist but my bet is there will be plenty probably. But there is a good chance there will be less of it than in 2011. Fear needs something to feed off, it needs fuel and I reckon there will be a little less fodder for the doomsayers this year. So each episode or turn in sentiment will probably be shorter in duration. As ‘animal spirits’ recover we should see that cash increasingly put to work.

So why will sentiment improve? Well for a start, it is difficult to continually talk about a double dip in the US. The idea was really only given credence in 2011 because of supply disruptions following the Japanese earthquake and some congressional tomfoolery. This hit global growth hard, which of course fanned talk of a double dip. US fundamentals are sound notwithstanding US government budget deficits and, as we are seeing, the US consumer is stirring – has stirred, in fact. That by itself should ensure sentiment is better this year.

Europe will clearly remain a problem and politicians there have promised that it will be a long road to recovery. But they have also ruled out a break-up of the eurozone and their actions seem to support that. Significant progress has been made in bringing Europe closer together and this new fiscal agreement is a good step. So while there is plenty of uncertainty left to deal with, things are a good deal more certain than last year. The ECB for its part is providing the financial system with unlimited liquidity on extremely attractive terms. This in turn (and combined the forex swap lines) should do much to avert a liquidity crunch or another GFC-type event and provide some support to sovereigns in their quest for funding. Recall that the Bank of International Settlements suggests that Italy can survive for years with higher interest rates. Credit to the private sector is more scarce in some cases as European banks shrink their balance sheets and certainly risk aversion has seen the cost of term credit rise. But as the Fed has repeatedly told its own banks, there are opportunities for others in the midst of this.

That, broadly, is the backdrop the way I see it. I’ll flesh out more detail in due course and will certainly discuss the market implications in more depth – and there are plenty. As usual, things are never straightforward and I’m not suggesting they will be this year. They are and will remain complicated and very volatile in our new world of excess liquidity and shot nerves.

Adam Carr is senior economist at ICAP Australia. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.

Follow @AdamCarrEcon on Twitter.


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