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The Mid Year Outlook For International Fixed Interest And Equities
Malaysia Perspective | 21 June 2012

By The Morningstar

Until the most recent Eurozone problems, it had looked as if global bond yields might have been headed back up to more normal levels. The US 10-year Treasury yield had risen close to 2.4 percent in the second half of March – still very low by historical standards, moving towards levels that made more sense in an economy with a 2 to 2.25 percent inflation rate.

All that changed in May as the latest Eurozone worries erupted, and ‘safe haven’ demand for US Treasuries had driven the yield back down to around 1.7 percent at the time of writing. Bond yields in countries similarly seen as refuges from the Eurozone’s problems also fell: the Swiss 10-year yield was down 0.2 percent over the past month to 0.65 percent, while Germany’s fell 0.3 percent to 1.45 percent. At the other extreme, yields in the weaker Euro countries increased: Spain’s rose 0.3 percent to 6.3 percent, Ireland’s rose 0.7 percent to 7.5 percent, and Portugal’s already high yield rose by a further 0.8 percent to 12.4 percent.

May, in sum, was a tumultuous month. The Barclays Global Bond Index has produced an overall loss of 0.8 percent, made up of gains on the government bonds seen as the safest, and losses on lower-quality governments and corporates notes.

The Outlook For International Fixed Interest
Few had expected that the Greek bailout, arranged earlier this year, would be the last word on Greece’s problems. Even if it had achieved all its reform and stabilisation targets – a big if – Greece would still have been left with an unserviceable debt burden. Equally, few expected that Greece would unravel again so spectacularly, so soon. Popular resistance to the austerity programme saw the incumbent government rejected at a general election, an inability by the winning parties to form a new government, runs on Greek banks, and the real prospect of Greek exit from the Eurozone and disorderly default on its debts.

On top of the direct impact on other European financial institutions of losses on their Greek investments, markets also started to worry about the commitment of the electorates in other heavily-indebted Eurozone countries to dealing with their debt problems – particularly Spain, where street protests have been endemic. Nor has it helped that the European authorities seem unable to agree on policies to assist Greece or other struggling Eurozone members, while the French electorate signalled its own degree of discomfort with reform and fiscal discipline by replacing former President Sarkozy with President Hollande.

In the absence of new policy initiatives in Europe, for the time being, it looks as if the ‘safety first’ conditions of the past month will prevail in coming months – a continuation of exceptionally low government yields in the more creditworthy countries and more expensive debt costs for lower-quality borrowers. In past episodes of the Eurozone financial crisis, there has been an element of babies being thrown out with bathwaters, and middling to good-quality corporate bonds have been sold off in the panicked flight to safety. There may be opportunities for fund managers to find value in the wider bond market sell-off. For the asset class as a whole, however, it will take evidence of concerted action to get on top of the Eurozone’s problems before more normal conditions return.

A Look At International Equities
World shares had been edging lower – the MSCI World Index slipped 2.9 percent between its most recent high point on 19 March and the end of April – and then the heavens opened as the Eurozone’s problems intensified. World share markets dropped a further 7.8 percent in the first three weeks of May. The evolution of market worries about Greece and the wider Eurozone can be seen particularly clear in the behaviour of the Chicago Board Options Exchange Market Volatility Index (VIX), a measure of how much volatility investors expect to encounter in the US share market.

In March, the VIX had traded at around 15, consistent with very calm expected conditions, and even at the end of April had only picked up to 17.2. In May, however, the VIX rose sharply to 25. All the major markets were affected by the most recent turbulence, the US down 6.5 percent, Germany 6.8 percent lower, the UK down 8.3 percent, and Japan down a sizeable 10.9 percent. The emerging markets were also swept away, with the MSCI Emerging Markets Index down 8.5 percent for the month.

International share markets have been heavily focused on the Eurozone’s issues. Disorderly defaults could threaten the global financial system, as investing institutions (particularly the European banks) potentially faced substantial losses on their loans. Austerity programmes could be mishandled in a vicious circle of ever-smaller incomes trying to service ever-larger debts. Political risks are high as governments attempt to enact structural reforms when their electorates’ tolerance for further disruption is low. And potential policy solutions remain at the mercy of unpredictably political negotiations.

The Eurozone’s problems clearly have the potential to spring further unpleasant surprises. At the same time, though, they are not the only moving part in the outlook for world growth and for international shares.

Outlook For The World Economy Still Encouraging
While there are downside risks, the outlook for the world economy is still moderately encouraging. Forecasters are edging back their expectations for 2012 and 2013 for some countries in light of the various Eurozone issues. In The Economist’s latest poll, for example, forecasters are taking a slightly dimmer view of the prospects for both Italy and Spain. But overall not too much has changed.

The Eurozone is the weakest part of the world economy and is expected to have a mild recession this year (-0.5 percent in gross domestic product) with a shallow recovery next year (+0.7 percent). Prospects in the rest of the developed world are brighter, with Japan’s reconstruction getting underway (+1.8 percent expected this year, +1.5 percent next), and the US continuing on a path of steady if unspectacular growth (+2.2 percent this year, +2.3 percent in 2013).

Outside of the developed world, virtually all the emerging markets are likely to do well this year, led by China and India. Although extensive publicity was given to an apparent slowdown in China on the basis of weaker-than-expected April data, this needs to be kept in perspective. Industrial production grew by ‘only’ 9.3 percent year-on-year in April, and consensus forecasts still have China growing by some 8 percent a year over the next two years (India is likely to post similar figures). Even if growth fell below this rate, the Chinese authorities have a great deal of firepower available to them to ramp growth up again, and have already begun to run more supportive monetary policy.

Uncertainties are high, investors are nervous, and there is undoubtedly scope for Eurozone policy inertia or even outright policy mistakes. All that said, the Eurozone is not the only ball in play, and ongoing moderate growth in the rest of the developed world, coupled with strong growth in the developing world, may yet lead international shares to perform better than their current downbeat expectations.

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