Debt – with a capital D. That is the most important issue facing investors today. Quite simply, there is simply too much debt, especially in the developed world, and it is constraining growth, as well as adversely affecting fiscal and monetary policies. And there is no easy – or quick – solution in sight.
Sadly, but perhaps typically, countries have not responded well to the debt crisis; the politics of populism has proved too attractive. Neither have the central banks. To a greater or lesser degree, they have bowed to political pressure to address unemployment and lacklustre economic performances.
What does this mean for investors in debt markets? In a nutshell, there is no simple answer. But we do expect the impact of ongoing global policy experimentation on real economic growth and financial markets will likely vary substantially from country to country.
Alpha variety
It is this variance that creates investor opportunity. But it requires an active approach to bond investment; passively floating through this investment environment is a risk too far.
Take sovereign bond exposure. If investors rely on market capitalisation-weighted indexes, the result could be holding more debt from countries that are less creditworthy or countries in which inflation risk is rising. Overexposure to peripheral Europe has been and may continue to be a significant investment risk. Who knows when the next Cyprus-style banking crisis will erupt?
So, although our expectations of total returns have been wound back because the lower yielding environment, there are more opportunities for potential alpha than could be expected in a “normal” investment environment.
Policy response
As countries choose different paths to address issues with debt, growth and inflation, so too will they provide alpha opportunities as the market reacts differently to economic events and the policy responses they evoke from governments and central banks.
In the developed world, many central banks are keeping policy rates at zero. Such policies have contributed to a significant slope in the yield curve, and that creates opportunities for investors focused on risk-adjusted returns.
Additionally, some central banks (including Australia’s) will likely deploy additional monetary stimulus through rate cuts and/or balance-sheet expansion in the year ahead, providing opportunities for active positioning.
Site specific
Country differentiation is critical when investing in global regions. Greater variation between countries is likely as the limits of debt sustainability and monetary and fiscal policies are tested to varying degrees. Ultimately, this may lead to more bond market volatility and changing correlations across the globe.
For example, the spread between Spanish and German yields at the end of 2012 was only 50 basis points higher than at the start of the year. Any appearance of calm, however, would be deceptive given that spreads oscillated substantially by up to 300 basis points throughout the year.
Expect volatility, and the potential for alpha, to remain the norm in a low-beta environment.
Peter Dorrian is head of global wealth management at PIMCO Australia
