Relative valuations speak in favour of equities and against AAA government bonds. However, despite attractive valuations and improved macroeconomic data, the EU’s national debts crisis is likely to prevent a strong equity market rally…
Swisscanto (Thomas Härter – Head of Investment Strategy)
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The debt crisis gripping the euro area is once again the number one topic. Ireland has already applied for help; it is probably just a matter of time until Portugal does the same. In the medium term, the euro area could thus continue to move towards a “transfer union” in which financially sound countries pay for the debts of deficit sinners. In today’s situation, it is assumed that either such a transfer union will become reality or that there will be restructuring of debts and bankruptcies.
Whereas a small borrower “belongs” to the bank, a gigantic one can “blackmail” the bank. The combined “blackmailing power” of Europe’s problem countries is, for the time being, big enough to at least temporarily obtain loans without appropriate interest. On 16 and 17 December 2010, the heads of state and government will discuss a mechanism for coping with crises which is intended to replace the measures adopted in May 2010 in mid-2013. The European Financial Stability Facility will probably remain in place. It is planned, however, to also involve the private creditors of government bonds that will be issued after 2013 in the costs of any rescue operation. The main problem is that the markets do not believe that there will be complete bail-outs, neither in the case of Greece nor in the case of Ireland. Politicians have forfeited too much trust recently.
The most probable scenario from our point of view is that until 2013 the transfer union variant will be preferred to that of restructuring debts, but that a middle course will be chosen for the time after 2013. This would make it easier for politicians from donor countries to find acceptance, in their own countries, for the costs of a permanent stability fund for deficit sinners, without being punished too severely by voters. Because, the voters in donor countries will not want to permanently pay for deficit sinners and the voters in recipient countries will oppose stringent reform policies and rising unemployment. The high credit mark-ups on problem countries’ long-term government bonds indicate that investors do not think that the emerging transfer union is tenable in the long run. The high credit mark-ups on government bonds with a short duration are largely attributable to the investment behaviour of decision-makers with major assets. If risks which had already hit the headlines turn into reality, the criticism for taking such risks will probably be harsher than in the event of risks materialising which were still largely unknown at the time of investment. In Ireland’s case, further reductions in the rating could also lead to (emergency) sales due to investment restrictions. We therefore retain our extremely cautious attitude towards government bonds issued by peripheral European countries. It is very probable that the market will also test the stability pact with regard to Spain.
Whereas the debt problem still awaits a solution, at least the danger of an imminent relapse into recession has been averted: The macroeconomic data from the USA and Europe came as a slightly positive surprise all in all. The data on the US labour market, in particular, give us hope. Equities remain favourably valued. Many bad items of news have already been taken into account in the prices.
We are not making any changes at the tactical asset allocation level. We keep equities overweighted, but expect markets to remain volatile and that there will be no strong price advances across the board. In our view, a rally will only be possible once a credible solution of the euro credit crisis has been established. We regard the European stock market as particularly interesting. We still prefer the cyclical sectors to the more defensive companies, and favour small caps over large caps in all markets. Due to the high holdings of liquid funds and the attractive valuation of many of these stocks, we continue to expect acquisitions made mainly by large companies. In addition, the current balance-sheet quality and profit expectations would indicate that many companies will buy back stocks and increase dividends, making their bonds attractive. We therefore overweight corporate bonds in relation to government bonds.
On the currency side, we keep CHF, EUR and JPY underweighted in favour of the commodity currencies CAD and AUD, as well as the SEK and now also the USD. We think that there is, in particular, a danger of the JPY weakening against the USD.
Source: ETFWorld
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