OUTLOOK

 

It was a punishing quarter for riskier fixed income and equity assets, with a long list of culprits to blame. In the US, the protracted debt ceiling debate and threat of a US default coupled with GDP revisions lowering economic growth to 0.85% in the first half 2011 dealt a blow to investor confidence. In Europe, renewed concerns over the sovereign debt crisis took center stage. Fears about contagion to Italy and the banking system further rattled investors, and global capital market liquidity began drying up. As worries about the strength of the global economic recovery intensified, investors seeking reassurance were confronted with tapped-out macro stabilization policies, the potential threat of a hard landing for the Chinese economy, and the looming risk of debt deflation and a lost decade.

 

In our opinion, the economic deceleration tipped the European crisis into a new and more dangerous phase. Nations require GDP and income growth to service their debts; thus, the slowdown in global growth prompted serious questions about debt sustainability in Europe. When contagion spread to Italy, which has the third-largest bond market in the world, the crisis hit a new dimension. The newly created €440 billion European Financial Stability Facility (EFSF) has enough money to fund Greece, Ireland and Portugal, but not nearly enough to fund Italy and its €1.9 trillion in debt. Italy has to roll over €300 billion in debt in 2012 alone. We have seen an inadequate policy response, and the markets are rioting.

 

As contagion spreads, investors normally look to macro stabilization policies to restore order and ease the burden of adjustment. Typically, a monetary policy response or fiscal expansion can snap the risk aversion and restore calm. However, we are in unchartered territory with regard to monetary policy. Does quantitative easing work? Is it treasonous? Can expansionary fiscal policy be implemented when public debt levels are high and rising? The stakes are very high, and the debate is fractured.

 

Amid the ongoing debate, the financial markets are signaling a need for liquidity:

 

• Credit spreads have widened dramatically.
• The US dollar has rallied on the back of risk aversion, similar to 2008.
• Interbank lending risk premiums have spiked, reaching mid-2007 levels.
• The European Central Bank (ECB) is directly lending over €500 billion to European credit institutions.
• Commodity prices have rolled over, and growth-sensitive currencies like the Australian dollar have declined.
• Yield curves have flattened, equities have been hit hard.
• Long US Treasury bonds rallied by just over 30% in the third quarter.

 

Until Europe and the US are able to demonstrate economic growth, the financial markets are likely to remain skittish, leaving risk premiums high. In the interim, policy-makers will be in the spotlight. In our opinion, central banks should supply more liquidity on a global basis in this turbulent environment. We believe such intervention can help assuage the markets.

 

In such a volatile and risk-averse environment, demand and supply dynamics can become dislocated, creating investment opportunities. By applying fundamental credit analysis to estimate realistic valuations and risk premiums, Loomis Sayles portfolio managers seek to take advantage of disarray in the markets. As selective buyers providing a bid in an illiquid market, our portfolio managers hope to capture an additional liquidity risk premium.

 

 

 

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www.loomissayles.com