Pricing for double-dip

Reuters | Fri Jul 2, 2010 | 11:08am EDT

New York Stock Exchange 2 With the global economy slowing, interest rates about as low as they can go, governments getting austere and banks being investigated for stress, it is getting harder for investors to keep putting on their bullish faces. Heading into the first full week of the second half, investors are still committed to riskier assets such as equities and high-yield bonds in their portfolios, but are being battered with questions about whether this is the right stance. Reuters asset allocation polls for June showed investors cutting stocks a bit, but retaining a long-held overweight bias toward them. They also moved into the riskier end of bonds, seeking yield. But markets themselves are telling another story.

After a brief rally early last month, world stocks have fallen almost steadily. What was shaping up to be a gain on Friday was only the second up day in nine sessions that have seen stocks lose around 8 percent. At the same time, bond yields are painting a picture of deep concern about the future. Citi’s composite world bond yield is only 1.8 percent, while short-term U.S. and euro zone yields are only 0.6 percent. "There is growing concern over the possibility of a double-dip recession in developed markets," said Rob Carnell, chief international economist at ING Commercial Banking. "In consequence, people want to keep their money as liquid as possible in case things start to turn down." Just about everything has been turning down from bond yields, to stocks, economic indicators and the Baltic Freight Index, a proxy for world trade. Friday’s U.S. jobs data will have done nothing to ease concerns, given that private employment gains were less than expected and that jobs are a lagging indicator.  


There are two implications from this. Either investors banking on a stock revival are wrongly positioned or bond yields are wrong pricing in something approaching an investment and economic Armageddon. Fred Goodwin, the "Mr Macro" analyst at a Nomura, leans to the latter. He says that once a recovery has begun to take hold, as now, double-dip recessions are very rare. The one in 1980-82, he reckons, only came about after the Federal Reserve had raised interest rates closer to 10 percent. "Positioning (now) for the double-dip, a Japan scenario, or a Depression does not offer compelling risk-reward at these levels of bond yields," Goodwin said in a note. Others are similarly unimpressed by the idea that another recession is on the way, particularly when it comes to corporate earnings performance, the main driver behind stock movements.

"A number of factors have been in place preceding previous global earnings recessions including an inverted global yield curve, excess inventories and unsustainably high profitability. None of these factors are apparent now," Citi equity strategists said in a note. That said it is hard to see where investors would find grounds to be bullish if the current recovery slowdown — epitomized by the latest manufacturing surveys — starts gain momentum. Reliance on Chinese and other emerging market growth could hardly be guaranteed if their main commercial markets started to retrench. And deflation fears are growing enough to prompt investors such as those at HSBC’s absolute returns team to buy 25- and 30-year bonds. They want to grab a near 4 percent yield they expect will soon fall as demand drives the price higher.


The week ahead is not likely to offer much that will help investors make up their minds about the future. The Bank of England and European Central Bank hold separate meetings, but both are likely to keep interest rates on hold. Germany will also auction some 10-year Bunds on Wednesday. Some auctions have been disappointing because record low yields have put people off. But this auction is expected to attract plenty of buyers because of a massive amount of cash that will be returned to Bund investor the same week from other maturing German issues. Austria might provide a better stress test, when it auctions 1.3 billion euros of benchmark bonds on Tuesday. The country is highly exposed to debt-stricken Hungary and is seen by markets as riskier than Germany and other core euro zone sovereigns. Investors, meanwhile, will also be looking for any early results from the European Commission’s stress tests on European banks, designed to see how they would cope with crises. Results for some of the biggest banks will be given to EU finance ministers on July 13 but leaks or announcements could come before then, especially about German regional and Spanish savings banks.


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