By Susan Gosling
With so much good news having been anticipated by markets in 2009, it was not all that surprising to see a more tentative start to 2010. However the risk-on/risk-off market behaviour has persisted into the second quarter.
As expected the flow of macroeconomic data has been uneven (although the US recovery does look to be on track) which has added to investor unease. But it is deteriorating public finances that continue to be the common risk aversion trigger.
We are in a period of heightened risk sensitivity. The synchronicity across risk trades has increased. Most notably, the Australian dollar has again been moving in lock step with equities. The link between the US dollar and Treasury yields has also been stronger, reflecting a general flight to quality. As fears about a default in Greece intensified, the US dollar moved higher and Treasury yields lower. The US 10 year Treasury bond rallied by around 80bps from their April highs, providing a welcome flow through into lower mortgage rates easing pressure on households.
The news in Europe has been considerably less positive. As concerns about Greek debt default intensified there was spill over to the other poor men of Europe, notably Portugal and Spain. And the near panic in May also triggered a decline in the Euro on break-up fears, and talk of parity to the US dollar.
The Australian dollar vulnerability comes from global growth fears and commodity price weakness, as well as the general deterioration in risk appetite. This market behaviour is consistent with adjustments we have made to MLC diversified funds’ foreign currency exposures. The proportion of the global equity allocation that is currency hedged was reduced in December 2009. This decision reflected three things:
– the highly optimistic level of the Australian dollar at that time;
– over-optimism about global economic prospects given the structural impediments to growth; and
– the vulnerability of the currency to a return of risk aversion.
In summary the higher foreign currency exposure reduces downside risk exposure.
Looking forward, the investment environment remains complex and uncertain. That Greece has not endeared itself to bond investors is obvious, but recent market action highlights a wider vulnerability. While current economic conditions in the major developed nations require more, rather than less, fiscal stimulus the risk is that investors will find the lack of fiscal rectitude unacceptable.
There must be convincing plans for spending cuts and higher taxes to control budget deficits. Without this debt will reach unsupportable levels in the major debtor nations – most the important of which is the US.
The intervention of the IMF has for now calmed fears about Greece. For others a balancing act is required to convince markets fiscal integrity will be restored. The risk is that the fears of the bond vigilantes seen in Greece will emerge elsewhere. And this is why it’s no longer right to think of sovereign bonds as the safe haven asset.
Looking over a series of years, while the ride may be anything but smooth, equities (selectively) may be a more reliable preserver of capital.
Susan Gosling is acting chief investment officer, MLC Investment Management
