Banca&Mercati

Governments will once again be in the firing line in 2012. Debt, budgetary retrenchment and growth are the three big themes that will dictate market trends. For the most optimistic observers, the Chinese Year of the Water Dragon will see a rebound. Pessimists, however, point to persistent uncertainties

EUR 800bn: this is the colossal amount Eurozone governments need to raise through bond auctions in 2012. Italy, which is expected to sell EUR 220bn in debt, is the focus of attention as its 10-year yields are still hovering around 6%. But the loss of France’s triple A rating had been largely anticipated and so failed to wreak the havoc some had been forecasting.
For the time being, the impact on French yields is still modest but the downgrade led to the EFSF (European Financial Stability Facility) rating falling to AA. The result, as we had expected, is that Europe is no longer an AAA, but rather an AA, zone.

Etienne Gorgeon, head of Fixed Income and Credit, Edmond de Rothschild Investment Managers

Heavy government funding requirements are also a cause for concern because of the danger of overcrowding. Sovereign borrowers will hog market liquidity at the expense of other economic agents and are prepared to use coercive means. They might, for example, introduce special measures to encourage banks, insurance companies and also households to buy national bonds.

Impacts on bond markets

Peripheral countries are still struggling with high volatility and prices are suffering as a result. In addition, negotiations over Greece’s debt have not yet been wound up. The IMF and the Euro group are urging banks and Greece’s government to rapidly conclude a viable agreement. The failure of these talks could trigger a default and increase creditor aversion to the Eurozone.
Yields in core countries, which are considered as safe havens, are less and less attractive. 10-year yields in Germany are close to 2% and below that level in the US despite the loss of its triple A. Current yields in both countries are no longer a bulwark against inflation and real interest rates for some maturities are in fact negative.
Even so, the ECB’s benchmark rate is expected to stay low. Bear in mind that to buoy economies, most of which still have their heads under water, Mario Draghi’s first action on taking up his post at the ECB was to stop the rising cycle initiated by his predecessor.
The question overhanging banks is how to clean up their balance sheets and help them finance the economy. To ward off a credit crunch, the ECB rode to the rescue, introducing a 3-year LTRO (Long Term Refinancing Operation) so that banks could in their turn lend to small and medium sized companies and fuel the economic cycle (production – jobs – consumption).
Investment grade and high yield companies still have abundant cash and low short term financing requirements so they can be expected to cope with adverse business conditions. As in 2011, corporate bonds – which outperformed other risk assets like equities and convertible bond – should continue to present superior risk/return profiles in 2012. They have no significant debt refinancing ahead so there is no reason why they should default. Investors are automatically attracted to their substantial risk premiums and undemanding debt issuing schedules.

In this context, which sectors and strategies favour?

The outlook for corporate debt is clearly better than for sovereigns. As far as asset classes are concerned, high yield bonds in particular should offer a better risk/return profile than equities. The CAC 40 declined by 17% in 2011 while high yield funds managed along wealth preservation lines only lost around 2%. The high yield segment also offers significant upside if markets rebound. Current prices factor in a lot a bad news, notably a severe recession (a scenario we do not believe in) so bonds are trading at large discounts.

Nevertheless, the credit universe will still face high volatility. That is why we have to be selective; that is the art of bond-picking. In this respect, our portfolios are characterised by strong sector bets. In investment grade, we are focusing on high-quality, non-cyclical issues with short to medium maturities. In today’s environment, we prefer geographically diverse companies like Saint-Gobain which have very stable cash flow. Cyclical sectors should find it harder to weather turbulent periods in the future as the cycle turns down. And after a bleak 2011, utilities will continue to suffer from government austerity plans. Financials are still dominated by systemic risk because of their exposure to sovereign debt.
In high-yield credit, the cable sector is one of our strong bets. We believe it will be one of the most resilient sectors as it benefits from recurrent income. Other sectors like food and packaging have similar strengths. In contrast, we are heavily underweight car companies, which should be hit by a sharp fall in demand.
To sum up, markets in 2012 will be swayed by four factors: debt auctions against the backdrop of the sovereign debt crisis, February’s LTRO, developments on Italy’s credit rating and any actions from rating agencies.
So far, the LTRO is apparently helping Spain and Italy secure refinancing in better conditions. Due to the pro-cyclical stance of rating agencies, however, there is still quite a serious risk that Italy might be downgraded further to the lowest investment grade rung. That would no doubt send market volatility higher at some time in the year.

Etienne Gorgeon