Looking forwards, the spectre of sovereign debt problems in Europe is not likely to be very far away.
However, for the moment things have calmed a little on that front. Europe’s leaders continue to work hard to find funding solutions for the peripheral borrowers in the eurozone and to strengthen the longer-term fiscal framework. There is clearly a desire to avoid putting any country into default and in that regard we have seen some positive developments surrounding Greece. However, I suspect that peripheral borrowing spreads will remain wide and we will see periodic bursts of volatility.
Soft patch?
At the same time we could get confirmation that the recent slowing of economic growth was a soft patch. Not that growth is going to bounce back, but fears of a double-dip and additional monetary stimulus might dissipate. If Japan’s production gets back on track in the months ahead and companies can start to rebuild inventories, then production and shipments data will turn positive.
Additionally, the global economy should benefit from a little bit of relief from the decline in commodity prices seen since May. Oil prices are down 10% to 12% from their peak and there has been some easing of food and other commodity prices. Global consumer price inflation will remain elevated by the rise in prices over the past year but it would be a positive development if we saw a stabilisation of commodity prices at current levels and no further large price increases.
Taken together, an easing of risk concerns, better manufacturing data and some relief on real income would be supportive to risky assets. Throughout the last year or so, there has been generally good news from the corporate sector. Forward earnings growth forecasts are in the 10% to 20% range while forward PE ratios are towards the lower end of the range of the last few years.
High yield benefits
On the fixed income side, this more positive outlook would benefit high yield. The spread (above government bonds) on the global high yield index has increased by 120bp since April, in line with the weak performance of equities. This has pushed the yield up above 7.7%, which is attractive relative to all other fixed income asset classes.
Although there is a pipeline for high yield issuance we are not overly concerned about the fundamentals of high yield; default risk remains low in our view. At the same time, we still think there is further to go on the inflation story. For the months to come we are likely to see headline and core inflation rates moving gradually higher and the risk is that inflationary expectations do get pushed up as a result.
We have already seen this in the UK where latest surveys of the public reveal an elevated level of inflationary expectations. So our preference for inflation protection remains in place and the combination of high yield and index-linked at the global level is one that historically has provided a nice risk-return trade off.
