The US Congress remains in limbo ahead of the elections at the end of the year and the focus on the Republican primaries to select their candidate to face Barack Obama in November, surely Mitt Romney, means that temporarily a dysfunctional Washington D.C. has moved to the back of the mind. However, the ideological battle between the desire of the Democrats to raise taxes and the Republicans to cut spending looks unlikely to end anytime soon and in the absence of agreement, Americans face a meaningful fiscal squeeze during 2012.
At the centre of this is the expiry at the end of 2011 of the payroll tax cut (the US version of the UK’s National Insurance) that saw it reduced from 6.2% to 4.2%. This has been temporarily extended to the end of February and there are hopes to keep it in place for the whole of 2012. The problem is that this is likely to weigh on consumer spending/confidence until it is resolved and is an issue of such magnitude that it has the potential to derail the current wave of optimism surrounding the improved recent performance of the US economy.
This policy of brinkmanship, apparent last summer when negotiations about the US federal debt ceiling went to the very last minute appears to be providing a blueprint for European politicians as well. We consider this situation to be most regrettable as it leaves very little room for error. It means that disagreements on relatively minor details risk much greater consequences.
At the time of writing, negotiations are continuing in Greece and whilst they are reported to be very close to reaching agreement, it seems we have been ‘close’ for the last eighteen months! A bigger challenge than simply agreeing the framework is the actual implementation of many of the proposals and in particular, the savings in Greek public sector expenditure may be hard to realise. Whilst it is very easy to sit from afar as we do and simply say they just need to make the necessary decisions, doing it on the ground is much more challenging with civil unrest potentially becoming more of an issue. The fact that so many of the conditions of the bailout have essentially been imposed by ‘outsiders’ also imperils the situation as no nation likes the idea of its sovereignty being compromised. There is also a very limited electoral mandate that makes it that much harder to deliver on; Ireland’s relative success amongst the periphery must in large part be attributable to the broad acceptance of the need for the changes.
All the laws of common sense suggest a deal will be forthcoming but frankly, the track record of European politicians during the last two years has been very poor and at almost every opportunity they have found a way of pushing the difficult decisions further down the road.
None of this has prevented investors adopting a more positive stance so far in 2012. We have noted before the extremely cautious positioning of many investors and how that had contributed to a widening gap between those assets seen as ‘safe’ (even if they are not) and those seen as ‘risky’. What we have seen in recent weeks is a strong rebound in almost anything that would be placed in the ‘risky’ category and almost without fail did badly in the final quarter of 2011 and investors adopted a cautious positioning at an accelerating rate.
Emerging markets stocks and currencies have done well whilst in developed markets the financials, miners and industrials have benefited somewhat belatedly from the better economic news out of the US relating to the fourth quarter of 2011. Within the bond markets the ‘safe haven’ sovereign bond markets have underperformed the European peripheral nations and high yield bonds have started to reverse some of 2011’s significant spread widening.
All in all it has generally been a very pleasant start to 2012 and we would very much like it to continue. However, it would be remiss of us to not point out that a tactical ‘risk on’ rally does not mean all that 2011’s problems have gone away. They have merely been pushed, temporarily, to the back of investors’ minds to re-emerge at a moment’s notice as greed takes over from fear.
A very reasonable argument can be made that in 2011, investors were pricing in an excessively high likelihood of a disorderly outcome in Europe but equally now it looks like they are being overly complacent. For those that have missed 2012’s ‘high beta’ rally we would probably caution against being in too much of a rush to join the bandwagon. Though a strong valuation argument can be made for this recent relative outperformance to persist, it feels like the rotation into such investments has probably run its course for the time being and the risk/reward is more balanced than it was.
Whatever the outcome and how the year unfolds it is pretty clear to us that the bond and stock markets are taking very different views of the situation. In broad terms, stock markets look to be pricing in muted economic growth and maybe a short-term recession in Europe with little or no regard for the kind of major event that would send markets lower. This might be in the shape of Europe sliding into a deeper recession, the Chinese economic miracle hitting a speed bump or the US economy faltering, or all of the above. This complacency is reflected in market volatility returning to subdued levels.
In contrast, whilst the divergence of bond yields between those nations seen as ‘safe’ such as the US, UK and Germany and those in some kind of trouble e.g. Spain, Italy and arguably even France has narrowed there remains an unsustainably wide divergence in the cost of borrowing within the Eurozone. Looking at corporate bond markets, the substantial spread over government bonds cannot be justified by any reasonable expectation of default rates etc. and looks the clear ‘value’ option within the fixed income space. You can also trade dividend futures these days and like the corporate bond market they suggest very tough times ahead for corporate Europe.
It is tough to reconcile that with the views of stock market investors who historically have proven overly complacent with respect to major market risks. We view it not so much as a question of who is right and who is wrong but the range of outcomes and the balance between favourable and unfavourable ones. The corporate bond market looks to offer a higher likelihood of a better outcome along with a narrower range of possibilities. For those turned off by the paltry yields of government bonds but who don’t want the risk of the stock market, we still think corporate bonds offer a pretty attractive middle ground.