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Inflation pressure could mount in the next recovery cycle

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Enzo Puntillo (pictured) , Head/CIO Fixed Income at Swiss & Global Asset Management, assesses the prospects for fixed income investments…

Inflation linked bonds have continued to post strong absolute returns. The strongest returns came from USD and GBP (4.8% and 6.3% respectively measured by Barclays index data) while returns from Europe lagged.

Over the cyclical horizon, inflation pressure remains subdued in nearly all developed economies. We think that inflation pressure could mount in the next recovery cycle, as huge monetary and fiscal stimulus is at work.

Real yields are low and offer only modest value from an absolute point of view (which is true for nominal yields as well). All developed linker markets (US dollar, euro, British Pound, Japanese yen, Swedish krona and Canadian dollar) meanwhile trade below 0.5% for 10-year real yields. However, the Australian dollar, New Zealand dollar and Japanese Yen remain the “usual” exceptions with real yields above 1%.

Ongoing “financial repression” policies (keeping low or negative real interest rates along with persistent higher inflation) together with recovering commodity prices could drive inflation expectations higher.

These bonds will prove popular among investors seeking to reduce the inflation risk of their investment. 
The hard currency emerging bond market delivered a negative performance in the third quarter of 2011 (-1.82%). However, the strong rally in treasury bonds helped contain losses.

Hard currency market: The asset class is not immune to global uncertainties on economic growth and the Eurozone debt problems. Nevertheless, credit fundamentals remain very solid. The current drop in prices is a good opportunity for long term exposure and returns.

Local rates: Our structural position in Brazil, as well as in selective inflation linked markets (Chile, Israel), continues to be strong.

Currencies: We expect that currencies are the least immune EM asset, as risk aversion and repatriation of capital will remain on the cards. Due to several macro factors (mainly growth differential, valuation and carry), we are long in Brazilian real and Mexican peso. On the financing side, we remain short in currencies which show clear signals of overvaluation or vulnerability to the global slowdown, for example, the Australian dollar.

The European banking sector continues to suffer due to its exposure to highly indebted peripheral countries. Deteriorating credit quality in several European utilities led to an unfavourable up/downgrade ratio by the rating agencies, which put pressure on recent performance.

Risk premiums in corporate bonds imply a recession. They are historically wide despite the strong fundamentals and good liquidity positions in the majority of companies from the investment grade universe.

On a sector basis, we are overweight in industrials. We prefer export-oriented debtors with strong cash flow generation capacity, low levels of debt and which focus on emerging markets.

We are cautious on financials, as several factors limit the potential for improving credit fundamentals: high exposure relative to equity in extremely indebted European sovereigns, margin pressure due to tighter regulatory environment and less government support for bondholders in bank debt going forward.

We are underweight in utilities as the negative trend in credit quality is likely to continue, and this is not reflected in current risk premiums.

Interest rates have moved from attractive to ‘no value left’ in most countries. We expect very low nominal, and in some cases negative, real yield returns for many government bonds over the next few years. For example, 10-year government bond yields in USD and EUR have fallen below 2% and yield curves have flattened further.

Valuations of government bond yields from most developed economies have become expensive, even if you base them on low structural growth rates and only modest inflation rates.

The Swedish krona, Australian dollar, British pound and Swiss franc stand out as the most expensive and the New Zealand dollar and Euro as the least expensive.

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