By Stephen Zinser
Hundreds of column inches have been devoted to the so-called ‘Great Rotation’ in recent months. After a long bull market in bonds, and pockets of better economic news, some investors and commentators are becoming twitchy. Fingers are hovering over keyboards, getting ready to rotate into equities at the first sign of rising interest rates.
The precedent was set nearly 20 years ago, but we would do well to remember it. Back in 1994, a 25 basis points rise in the Fed Funds rate led to a three percentage point rise in US interest rates a year later, a 240 basis-point rise in 30-year US Treasuries and the bankruptcy of several leveraged bond investors, including Orange County. The question is, where are we in the cycle? Are the storm clouds rising?
Our clients are increasingly sharing their concerns with us about the outlook for credit. They’re right to worry about the impact of rising interest rates. From current yield levels, rising interest rates would indeed be painful for bonds. The unanswered question is whether the extraordinary measures being executed by central bankers will eventually lead to sustainable growth. We believe that, eventually, stronger growth or higher inflation could trigger a disorderly sell off. But, the fundamentals indicate we’re not there yet. While the US economy is holding up well in the face of the payroll-tax rise and sequestration, growth remains below trend. Meanwhile, the European economy remains deep in recession, mired in structural problems and hamstrung by its complex politics.
Our clients are also right to note that bond yields are at very low levels in absolute terms. Sovereign bond yields have been suppressed by central bankers. Because of this, yields on spread products have been squeezed – to all-time lows in the case of high yield. Continued quantitative easing, however, is keeping a lid on yields.
And they’re right to note the negative impact of the changing regulatory environment. Since the financial crisis, European banks have been trying to rebuild their balance sheets. Despite this, there is still some way to go – which should restrain growth and inflation for a while longer.
Meanwhile, banks face the headwind of onerous Basel III capital adequacy requirements and the desire by many European governments to cut back their stakes in the lenders they bailed out during the crisis. Investors are also understandably working through the broader implications of developments in Cyprus. On the positive side, higher yields are available in financial credit than in other areas of the credit market, and there are attractive terms available to investors.
Putting this all together, we predict 2013 will give us modest growth in the US and stabilisation in the second half of the year in the eurozone. This is a reasonably favorable environment for credit markets. That said, we do expect core government bond yields to drift higher throughout 2013 – and this would most likely counterbalance excess credit returns.
Stephen Zinser is CEO & co-CIO at ECM Asset Management
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