28th October 2010
Since that August dip in the US and UK, the FTSE 100 has gained around 12%, the S&P 500 13% and Dow 12 %. Yet ‘residual risk', such as fears of a full blown currency war and resulting rise of protectionism, are still with us. But having considered all these various, persistent negative factors, Philip Poole, head of macro investment strategy at HSBC, is confident that there is still scope for possible to secure good yield and returns in markets which can boast strong fundamental anchors.
"Certainly risks remain and investors should be careful not to minimise them. But given the balance between residual fundamental concerns and the monetary policy and liquidity implications that follow from them, the conclusion is broadly the same. This combination remains generally positive for risk assets," he says.
Poole argues, for instance, that despite the downward pressure on yields in developed markets on expectations of yet more QE – certainly the US looks set for QE2 next month – there still appears to be value in emerging markets debt.
Equities, however, look "more difficult to call" given the continued overhang of fundamental weakness in the developed economies. Having said that HSBC remains keen on Russia as an emerging equity market. Despite Russian equity valuations moving up they are still in general trading below historical multiples.
Elsewhere, concerns about currency wars are palpable, as this Wall Street Journal report shows, and while a US QE2 will be dollar negative, it should, on the other hand, be positive for carry currencies where growth remains robust, not just in emerging markets but including developed markets like Australia. (Carry currency trading entails an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.)
There is however growing concern that the flow of hot money into emerging markets, as investors look to exercise more risk, secure higher yield and return, could trigger heavy inflationary pressures in these economies, which in turn could result in asset bubbles. This very concern was voiced only yesterday by Fitch Ratings, as reported by International Business Times.
But while valuations in some of these markets are now looking stretched, in Poole's view we are not yet in generalised bubble territory. Having said that, he believes policy makers in emerging economies need to tighten to prevent overheating, though he concedes in raising rates they run the risk of sucking in more funds as interest rate differentials widen.
Poole recommends that as well as remaining exposed to carry currency trade, thereby making interest rate differerentials work for them, investors should buy some emerging markets inflation protection via linkers such as inflation-linked bonds.
As for the troubled eurozone, sovereign debt contagion from countries like Greece, Spain and Portugal seems to have been contained by eurozone authorities and IMF. But, as the Daily Telegraph reports, Europe's debt nightmare has returned after Greek premier George Papandreou called for fresh elections. Yields on 10-year Greek bonds soared and the euro tumbled against the dollar as the news spooked investors. Warnings from bond giant PIMCO, meanwhile, that Athens will default within three years only added to worries that the eurozone was back in crisis mode over sovereign debt.
Some economists believe Germany may well have to exit the euro to allow an orderly resolution to the eurozone crisis, as reported by Mindful Money.
Poole says that while some progress has been made by the most troubled eurozone countries, the future refinancing burden upon them remains heavy and concentrated and there is no guarantee that Greece, for example, will be able to regain market access on sustainable terms without first alleviating its heavy debt burden.
More generally, he makes that observation that the inability of the eurozone most troubled ‘peripheral' countries to adjust via currency depreciation means that competitiveness in countries like Greece and Spain can only be restored by changes in relative prices and wages.
Leaning on his experience from the emerging markets debt crisis of the 1980s, Poole reckons eurozone's woes are likely to be much more drawn out than currently being anticipated. This will mean the zone going through a more difficult adjustment process than if it was accompanied by currency depreciation.
Without appropriate discipline across euroland, Poole believes there is a risk that the markets' belief in monetary union and faith in the euro will be undermined again in the near future. "In effect, euroland's problem has not been solved – the can has just been kicked down the road. Peripheral eurozone economies are implementing austerity programmes but there remains a big question about their ability to stay the course and regain market access to debt on sustainable terms."