The Year The Music Stopped

As is customary at this time of year, it seems appropriate to look back at how markets have performed and to make some predictions about the outlook for next year, 2012. However, before launching into any detailed analysis, I believe the most important development in the last year was a change in investors’ attitudes towards some of the basic assumptions that have underpinned investing over the last half century or more.

By this I mean the loss of faith in developed countries’ government bonds as the “risk free” asset class against which other investments should be measured, as well as the crumbling of belief in fiat (paper) currencies. Since the end of the Second World War, no developed country has defaulted on its bonds, or reduced the interest rate it paid. this contrasts sharply with the inter-war period, when defaults and cuts in coupons were commonplace, and with emerging markets. Yet after the last eighteen months, there are few observers who do not now expect other countries to follow in the footsteps of Greece, which imposed a “voluntary” 50% haircut on its private sector bondholders as part of the second bailout package announced in November. Furthermore, because the haircut was supposedly voluntary, the insurance against such an event which bondholders had purchased in the form of Credit Default swaps (CDS), was not triggered!

The inevitable result of such an attempt to circumvent the market was a flight by bondholders out of the sovereign debt of other countries in the PIIGS (Portugal, Ireland, Italy, Greece and Spain) group whom investors suspected of following Greece’s example. Portugal and Ireland had required bailouts in 2010-11 when their 10 year bond yields rose above 7% as Greece’s had done in May 2010, and by early December, Italy and Spain had both seen their 10 years yields also exceed the vital 7% level. While heavy bond buying by the European Central Bank has brought yields back below 7%, and the recent announcement by the ECB of a 3 year Long Term Repurchase arrangement which lets Euro-zone banks borrow unlimited amounts at 1% provides support to the banking system, the underlying systemic problem remains.

When the US Federal Reserve and the bank of England (BoE) undertook similar arrangements in 2008-09, it allowed their banks to borrow at very low rates (at or below 1%) and invest the borrowings in longer-dated government bonds paying 2%, 3% or even 5%. Riding the yield curve like this, while using 10-15 times leverage is a licence to print money and recapitalized the US and UK banking systems. unfortunately, the ECB rapidly began to reduce the amount of cheap funding it was supplying, which in turn led directly to the original Greek debt crisis in may last year. Ironically, now that the ECB under its new President Mario Draghi has shown itself willing to follow in the footsteps of the Fed and BoE, Euro-zone banks are too afraid to do so, as they are not certain that the government bonds they invest in will repay them in full. Domestic investors in Italian or Spanish bonds, for the first time in over half a century,  face the prospect of suffering capital losses on government debt, as domestic Greek investors already have experienced.

Along with the realization that developed government bonds can default has come an awareness that currency unions can break up if they are not backed by a fiscal union with the power to raise taxes or issue bonds backed by all countries in the currency bloc. The belief held by investors over the last decade that Greek, Portugese, Spanish and Italian bonds were only marginally more risky than German bunds has disappeared, and brought the realization that a currecny union does not remove currency risk. Why this should have come as a surprise is an interesting question. less than 20 years ago, Italy and the UK were forced out of the predecessor to the Euro, the ERM, leaving investors with 30%+ losses in DM or U$ terms.

As a result, investors in 2011 have experienced losses of more than 15% in European markets such as the German DAX and the French CAC-40, before taking the weakness of the Euro against other currencies into account. Even European countries not in the Euro-zone such as the UK have lost 5% and Japan is down almost 20%, while resource dependent Canada is off more than 10% too. Emerging markets didn’t fare any better, with the BRIC (Brazil Russia India & China) countries all down more than 20% except for Russia and commodity indexes were affected by slower growth, falling around 5%. The best performing major market is the US, which is effectively flat on the year, helped by the resilience of the global multi-nationals, with the Dow Jones Industrials up 8%.

Yet bond indexes were all up sharply, with the exception of the economically sensitive high yield and emerging markets sectors. Despite starting the year with 10 year government bond yields at 3-4%, most bond indexes produced a total return of 10% or more, with investment grade corporates lagging at 7-8% and governments outside of the Euro-zone returning investors 12-14%. German bunds were the only Euro-zone bond market to achieve a similar return as they were viewed as a safe haven, along with UK gilts, and US Treasurys, both selling at yields that had not been seen for over 60 years by the end of 2011.

It seems reasonable to expect that this pattern will not be repeated in 2012. Bond yields are now so low in developed countries regarded as not at riak of default that any increase in grwoth or inflation should lead to falls in price that will more than offset the very low absolute yields now available. Meanwhile, after the second bad year in four for equities, valuations for non financials are reasonable and the dividend yield on the indexes, let alone on stable businesses with good balance sheets, are higher than bond yields, for only the second time in the last 50 years. Assuming that governments are successful at offsetting deflation by their money printing efforts, then it would reasonable to assume that economically sensitive assets such as equities and commodities will once again be the beneficiaries, as they were in 2009 and in late 2010-early 2011. Investors should never underestimate the ability of a central bank with a printing press to raise the price of assets initially. Of course, it may not be the asset whose price they’re intending to raise, but some assets will go up in price. in fact, unless the European authorities are intent on reliving the 1930s, then inflation is the answer to the credit problems that their banks face.

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