Debt concerns spoil holiday cheer

By Natsuko Waki

LONDON (BestGrowthStock) – Investors get down to the final weeks of a year that has seen healthy gains on risky assets with a nagging feeling that a reasonable growth profile next year would trigger an even more drastic sell-off in government bonds.

U.S. Treasuries have been sold off, pushing yields to a seven-month high, after President Barack Obama reached a deal to extend tax cuts, sparking concerns over a widening budget gap while also boosting hopes for U.S. economic growth.

This comes as world stocks, as measured by MSCI (.MIWD00000PUS: ) raced toward a two-year high, bringing this year’s gains to nearly 9 percent.

In the week to December 10, bond funds saw a weekly outflow of $0.9 billion on a four-week average, according to JP Morgan, while equities drew an average flow of $2.6 billion.

The euro zone debt crisis is far from over, with Friday’s deep downgrade of Ireland’s sovereign ratings fanning fresh concerns. But the risk is for a wider contagion.

“There is a risk that the sovereign crisis will spread across the Atlantic to the U.S. … There’s already evidence that it’s turning to disorderly unwinding,” said David Woo, head of global rates and currencies at Bank of America Merrill Lynch.

“There are clearly very uncomfortable positions in the market that will be unwound, especially if data holds up. There is a 30 percent chance of a serious turmoil in the bond market.”

Woo expects 10-year Treasury yields to rise to 4 percent by the end of 2011.

A shift out of government bonds to equities in itself is not a worrying phenomenon, with investors who have a bigger risk tolerance chasing higher-yielding assets.

But a resulting spike in yields pushes up long-term borrowing costs, which weigh on the ability of corporates and governments to finance themselves.

Benchmark 10-year U.S. Treasury yields rose above 3.5 percent in the past week, their highest since May.

“Investors have been crying wolf about government bonds for two years: maybe the wolf has now arrived, just as everyone has learned to ignore the warnings,” noted Max King, strategist at Investec Asset Management.

“If bond investors switch from complacency to paranoia, 10-year yields … could rise much further. Higher yields would, in turn, further undermine sovereign credibility, shutting all but the best quality borrowers out of the market.”

JP Morgan says there is a strong relationship between past bond returns and mutual fund flows.

Historically, bond fund flows turn negative when the 12-month return on the Barclays U.S. Aggregate Bond Index — an industry benchmark — falls below 6 percent.

JP Morgan expects the 12-month return to fall to 6 percent in the second quarter, then reach 3 percent by the end of 2011.


Against this backdrop of favoring equities, the Volatility Index, a barometer of investor anxiety, has fallen to eight-month lows below 17 percent (.VIX: ), approaching levels seen before the start of the credit crisis in 2007.

As many as 92 percent of fund managers polled by the Association of Investment Companies thought equities will rise in 2011 while 80 percent of them thought equities will be the best performing asset next year.

An overwhelming preference for equities among asset managers does raise a risk it is becoming too much of a consensus trade.

“Investors will be surprised by the ability of financially-strong, well-managed blue chips to grow sales and profits, even in an anemic growth environment,” said Andrew Bell, chief executive officer of Witan Investment Trust, which took part in the AIC poll.

“However, the variable growth backdrop will not be enough to re-float all boats so an emphasis on quality is called for.”

Morgan Stanley’s analysis based on 15 years of data shows equities rise until government bond yields approach the level of nominal GDP growth, at which point yields would effectively no longer be negative and would be less supportive for risk assets.

The bank expects nominal U.S. GDP growth of 4.5-5 percent in 2011. This leaves about 1.6 percentage points of yield upside for equity investors before they start turning cautious..

(Editing by Catherine Evans)

Debt concerns spoil holiday cheer