Australia On Hold

After two straight months of rate cuts, the RBA held rates steady; a reflection of increased market optimism and moderating financial pressures on European sovereigns and banks.

Global Fixed Income Strategy | Australia On Hold

T he RBA left the cash rate unchanged at 4.25%. Governor Stevens’ tone has become much less dovish than at the December meeting but policy continues to be focused on external factors: the Chinese economy and European sovereign and bank worries. Over the past two months, market expectations of rate cuts have moderated by roughly 50 bps, however 75 bps of rate cuts over the next 12 months is still priced in.

We continue to be apprehensive of these expectations and believe they are overdone. However, longer-term spreads versus the U.S. (and therefore yield levels) are likely to remain range-bound even as policy expectations may be unwound. On the domestic front, the RBA stated that the Australian economy’s growth is near trend, inflation is nearing its target range and borrowing rates are hovering close to their medium-term average as a result of the rate cuts in the last two months of 2011.

In short, the RBA seems satisfied with the pace of current growth. Barring any major shakeup in the European debt crisis or a hard landing in China, we expect the RBA to remain on hold.

Our Global Fixed Income Strategy service continues to recommend a neutral weight for Australia in a hedged global bond portfolio. Signs of a hard landing in China would prompt an overweight allocation.

U.S. Employment: The Consequences Of Less Participation

Investors should focus on U.S. job growth rather than the unemployment rate. The latter is a victim of a stagnating labor force.

U.S. Employment: The Consequences Of Less Participation

T he labor force has not grown since the beginning of the recovery, and the labor force participation rate has actually been in structural decline since 2000. This rate is the percentage of the working-age population reporting themselves as either working or actively looking for work.

For much of the past four decades, the participation rate has trended up, but it has declined by three percentage points in the last decade. Such a decline is unprecedented in the post-war experience and has occurred both during the recession years and economic expansion. The participation rate for 25-54 year olds has held constant over the past two decades but 16-24 year olds participate much less in the work force, presumably because more years of education are now needed to find suitable employment. This has not been offset by the growing numbers of 55 years of age-and-over workers who are staying in the labor force.

There are long term consequences for the economy: trends in the labor force participation rate have a close historical relationship with long run productivity (higher participation rate means higher productivity) and thus need to be monitored. Unfortunately, it is difficult to extricate to what extent the downturn in participation is due to structural versus cyclical factors given the historically severe recession.

For these reasons, market participants would do better to focus on job creation rates rather than the rate of unemployment.

U.S. Equities: The Total Return Trap

High dividend yields hold appeal in a sluggish economic environment. But, investors should be wary of overpaying dividend streams in overvalued groups.

US Equities: The Total Return Trap

T he Fed stretched out its zero-rate expectations even further last week, reaffirming that low interest rates will remain a key feature of the investment environment. This would seem to continue to favor high-income-generating assets, but our U.S. Equity Strategy recommends that investors should be selective when looking for total return plays. Valuations of traditionally high-yielding equities are well beyond levels justified by underlying earnings. For example, equity fixed income proxies like utilities, telecoms and REITs are overvalued according to our industry valuation models. On the other hand, pharmaceuticals, integrated oils and hypermarket equities offer a high yield at prices that are not demanding versus their own relative valuation histories. Also, these equity groups (unlike the traditional high yielding ones) offer protection should long-term Treasury yields rise on the back of positive economic surprises.

Bottom line: Traditional high yielding equity sectors have very demanding valuations, and investors seeking total return should consider other less popular yield plays, including pharmaceuticals, hypermarkets and integrated oil & gas.

Fed Chairman Heavily Skews the FOMC Statement

The FOMC statement was on the dovish side, but almost two-thirds of policymakers would raise rates before the end of 2014.

Fed Chairman Skews FOMC Statement

T he FOMC signaled a later start date to the next tightening cycle, stating that exceptionally easy policy will be required “at least through late 2014”. The weighted average of the newly released fed funds projection across 17 policymakers was roughly in line with market expectations, in both real and nominal terms. Interestingly, however, data on the appropriate timing of policy firming shows that 11 policymakers would begin raising rates before the end of 2014 (three favor hiking in 2012). These include projections from non-voting members, but the divergence with the forward guidance language in the Statement shows that Chairman Bernanke and other high-profile FOMC members are heavily skewing the tone of the Statement in a dovish direction.

If it were a simple majority vote, the Fed would be inclined to tighten much earlier. In theory, one benefit of the new communication strategy will be to reduce volatility in the Treasury market, especially during periods when growth is surprising on the upside. Policymakers could use the rate projections to temper Treasury selloffs that risk prematurely tightening financial conditions and truncating the fragile recovery. However, it is not clear how the market will react to seeming inconsistencies between the FOMC statement and the rate projections, were they to persist and widen. The new policy could potentially backfire by adding uncertainty rather than reducing it. Still, investors should watch the Chairman as he will clearly continue to dominate Fed policy, no matter what happens with the rate projections.

Another Tough Year For Europe’s Periphery

The weakening euro will eventually help Germany to revive its export sector and contribute to growth. However other countries in Europe are less lucky.

Tough Year Europe's Periphery


I mbalances within Europe have developed gradually since the creation of the eurozone, resulting in a cumulative current account surplus in the core countries and a current account deficit in the non-core areas. Fiscal austerity is limiting growth, which contributes to a rebalancing across countries by dampening import demand. The extensive fiscal austerity measures implemented in Spain, Italy and other non-core markets have offset the automatic stabilizers that otherwise would smooth out GDP growth in times of crisis, so the recession could be quite severe within these countries. S&P’s real GDP forecast for the eurozone is +0.2% in 2012, so a less rosy growth outcome could trigger more downgrades.

Our model projects eurozone GDP of about -1% this year.

The mild recession represents our base case scenario for the euro area as a whole, but this will be concentrated in the periphery.

Bottom line: Recessionary forces are significant in the peripheral countries, which keeps pressure on sovereign spreads as these countries struggle to meet debt targets. Stay neutral non-core Europe within a global hedged fixed income portfolio until there are clearer signs of growth and lower political risk.