2012: A year in global bonds

Some of our mature readers may recall the song performed by The Vapors, a punk rock band from the early eighties. Their one major commercial success, ‘Turning Japanese’, was probably not an attempt to forecast the possible similarities in economic downturn between Japan in the early nineties and the broader Western world today.

But can the experiences of Japan – 20 or so years of stagnating growth with persistent concerns over deflation – be a useful guide for the investment climate facing us today? Can policymakers avoid another year of turmoil and concerns over recovering from our own asset price bubble?

At first glance, there are clear similarities between the Japanese downturn and the problems faced by most of the US, eurozone and UK today. But there are also key differences, not least policy makers’ response to the crisis as well as the emerging world’s growing importance for global economic growth and prosperity.

Japanese parallels

Let us briefly start with the similarities:

Japan’s downturn followed the bursting of the bubble in overinflated property and stock prices. This was caused by lax lending standards in the Japanese banking system. The result was ‘zombie’ banks hoarding liquidity and the Japanese consumer saving aggressively, leading to economic stagnation and over-leveraged banks. To boost growth, the Japanese authorities invested heavily and initiated a number of bank bailout packages. However, after witnessing declines of up to 60% in land and stock prices, Japanese companies and households adopted a more cautious attitude to spending. Today, savings rates in Japan remain among the highest in the world. While households and corporations have increased their savings, the government has continued to run an impressive budget deficit. Government debt as a share of GDP is now estimated to be around 200%.

Clearly many similarities exist with the situation in the US, euro area and UK today. These countries allowed banks to expand their balance sheets aggressively and to lend too heavily to consumers. The consumers then borrowed beyond their means, driving property prices to levels inconsistent with conventional earnings multipliers.

The resulting collapse in, most notably, US property prices and more generally stock prices, was met with aggressive cuts in interest rates, significant government stimulus packages and capital injections into a number of, otherwise, zombie banks. With many central banks reaching the zero bound of interest rates, quantitative easing (a polite form of monetisation) has been widely used in an attempt to ward off threats of deflation. Government debt has ballooned as a share of GDP.

Central bank responses

On the surface, this is a near carbon copy of the Japanese experiences. However, one key difference is the time between the pricking of the property bubble and the speed of response to the ensuing credit crunch.

Initially, the Bank of Japan felt constrained in its ability to adopt the more unconventional measures by the country’s high levels of nominal savings. It was concerned about the risk of a steep rise in inflation, destroying the real value of savings. The ruling political party was also concerned about the state of government finances. As soon as it felt growth was returning to trend, it tightened prematurely and dragged the economy back towards recession. The drag caused by Japanese banks hoarding cash and failing to lend was felt for six or seven years, before a bank bailout was organised.

While the policy responses to Japan’s problems are very similar to authorities’ response to the 2008 credit crunch, the speed of response is a key difference. Deflation is not entrenched, and while consumers are rightly living within their means, they are not driving their savings ratio ever higher.

Political progress is likely to be slower than markets would like and while we do not believe governments of the eurozone will allow events to push economies over the edge of the precipice, the risk remains

Bob Jolly

Where next?

Two debt crises are never the same. Today, we face considerable uncertainty over the eurozone’s response to the concerns markets have about the solvency of nations’ finances in Spain and Italy, among others. The US political system is a year away from a national election resulting in both sides of the political spectrum playing politics rather than sound economics in response to an elevated level of both debt and unemployment.

What is clear is that overspending by governments has to be brought under control. Two irrefutable facts have to be dealt with:

First, we are living considerably longer, existing retirement ages were set before medical advances extended our life expectancy. We will have to work for longer before retiring. Government finances are under increasing strain by the need to pay for the growing retired population in part because their medical expenses continue to increase. Means testing of healthcare is likely to be introduced at some point in the not too distant future.

Second, an increasing divergence in expected growth has to reverse. While the West has accumulated too much debt, the developing world has increased its wealth considerably. Asia and the developing world in general have in the last decade built up considerable trade and current account surpluses. The cause is twofold: first, a seemingly insatiable appetite of Western consumers for Asian-produced goods; second, the preference of some Latin American, but more importantly Asian, currencies to maintain a competitively pegged exchange rate with the US dollar. Some rebalancing of the world’s demand will be achieved by consumers in the US and the southern European countries spending less but also a move toward freely floating exchange rates in the developing world.

The eurozone has to either accept greater integration or agree to abandon the euro project.

Bob Jolly

What is in store for 2012

For 2012, we expect progress in a number of areas;

The eurozone has to either accept greater integration or agree to abandon the euro project. The problems faced today in Europe are largely caused by growing divergence in expected growth rates made unsustainable by a narrowly defined union of currencies with a common interest rate. Structural reform is required, and a deeper integration of fiscal policy a necessity of success in the euro project. Without it, the rifts will grow, and the problems become more acute.

While the required reforms may be unpopular, markets and sound economics will force policy makers into the required adjustments, although the progress may be slower than markets desire.

Elsewhere, central banks will continue to adopt unconventional measures, quite probably in increasing size and regularity, to reduce the impact of tighter fiscal policy and a deleveraging of both bank and household balance sheets.

Asian currencies will most likely continue to appreciate, perhaps not at the speed with which the US administration, among others, calls for but for their own domestic reasons, such as reducing high inflation and increasing the purchasing power of domestic consumers.

While the equity multiples and credit spreads of before the credit crunch are clearly an inappropriate period to use to calculate market equilibrium, considerable bad news is already in prices.

Bob Jolly

Investment conclusions

Markets do not like uncertainty. Political uncertainty is likely to remain high throughout the Western world, but events in the Middle East continue to add to the uncomfortable environment we find ourselves facing.

However, while the equity multiples and credit spreads of before the credit crunch are clearly an inappropriate period to use to calculate market equilibrium, considerable bad news is already in prices.

We continue to find corporate bonds issued by strong companies with cash on their balance sheet and pricing power attractive.

Government bond yields of countries with their own exchange rate are anticipated to remain extremely low. Assuming progress can be made on the further integration of European members of the euro, at some point the likes of Italy and Spain will offer good value.

However, political progress is likely to be slower than markets would like and while we do not believe governments of the eurozone will allow events to push economies over the edge of the precipice, the risk remains. We continue to trade our portfolios more tactically as volatility remains high.