With US 10 year bond yields hovering around 2%, more and more investors will look to higher yielding bond markets, says Gary Dugan
Source: Private Banking, Emirates NBD , Author: Gary Dugan
Posted: Thu January 26, 2012 6:52 pm

UAE. As we start of the Chinese year of the Dragon there are signs of improved investor confidence in the financial markets. The extreme ups and downs of markets have subsided. For sure there are challenges but the current positive mood may lead to further gains in markets.

Interestingly according to Goldman Sachs research in the last 140 years the year of the Dragon has brought an average 8.3% return for US equities. As always a word of caution the Dragon may turn nasty at any time with the problems in the Euro zone still a worry for the markets

Equity markets have continued their gains as good global economic data has remained generally supportive of markets. In the back ground, the Euro zone news flow has been quieter helping investors to rebuild their confidence and risk appetite. Interestingly the rise in equity market has continued with only limited buying by investors. Money flows in equity mutual funds have generally remained muted and the latest Merrill Lynch survey of investors’ sentiment shows only modest increases in investors’ positions in equities.

Let's consider the positives
US economic data has remained upbeat. Latest employment data shows ongoing marginal improvement but more people in jobs all the same. Industrial and consumer confidence has improved. Although the data on real spending is not overwhelmingly strong, investor fears of a double dip US recession are a thing of the past. In the past week the report on industrial production growth for December was stronger than expected and industrial confidence rose sharply. U.S. industrial production rose 0.4% month-on-month in December.

The U.S. Empire State industrial confidence index climbed to 13.5 in January up from 8.9 in December. The U.S. Philly Fed manufacturing confidence index rose to 7.3 in January after rising 3.7 points to 6.8 in December. Encouragingly the surveys of future employment trends improved in both reports.

Even in the housing sector there was better news. The US survey of national home builders’ confidence jumped to the highest level since June 2007. U.S. existing home sales jumped 5.0% in December. The months' supply of homes fell to 6.2 months from 7.2 and the median price rose to $164,500 from a revised $160,800. Lastly in the US, people are taking out more mortgages, the U.S. MBA mortgage market index surged 23.1%, while the purchase index rose 10.3% and the refinance index bolted 26.4% higher for the week ended Jan-13.

The Euro zone may be a long way from solving their problems but at least for the moment some sense of calm has transcended the situation. The European Central Bank using all of the instruments at its disposal has managed to bring some of the periphery country debt yields down to levels that are less crisis like. Italian 10 year bond yields that were at one stage hitting 7.5 pct are down at 6.5pct.

Government bond sales that were struggling to find buyers are now relatively well received. In another measure of improved sentiment the German ZEW investor confidence jumped to -21.6 in January, from -53.8 in the previous month against expectations for a slight improvement. The ECB action to lend to the banks in December of last year appears to have provided considerable stability to the banking system.

The Euro zone banks are less pressed to sell assets to improve their balance sheets and hence the banking crisis has abated at least for the moment. In Spain for example, Euro 31 billion left the banking system inDecember but the banks were able to make up the gap with borrowing from the ECB.

The news-flow in the emerging markets remains strong. Emerging markets equities and bonds have responded with some recent good returns. Chinese GDP growth and industrial confidence data came in ahead of expectations suggesting that fears of a hard landing by the Chinese economy are misplaced.

Many investors who sold emerging market debt and equity last year must be worried they may miss out on good performance from an investment that they would want to hold long term holders of.

We find more and more investors returning to invest in emerging markets. Our preference remains for Brazil and China where there is the greater scope for cuts in interest rates and general easing of monetary policy.

Now, before anyone gets carried away and thinks that all problems are resolved and we can look to an undeniably better outlook, there are a few things to consider. US economic growth will be hit in 2013. Post the presidential elections, the new President will have to address the budget deficit through likely tax increases and spending cuts that are likely to restrain economic growth.

In the Euro zone the governments have bought time, however there are structural deficits that have to come down and aggressive debt reduction (growth reduction) policies that have to be put in place. In the very near term, a default of Greek debt and or a marked deterioration of the US employment data which has to weaken somewhat after the previous months surprisingly good data could all lead to some profit taking.

The current negotiations over the restructuring of Greek debt have both the potential to encourage but also collapse the markets. Recent negotiations over the restructuring of Greek debt have moved in a positive direction. Many of the major holders of Greek debt appear to be agreeing to terms that would allow for an orderly write-down of Greek debt where existing holders would receive new bonds worth around 50% of the face value of existing bonds.

As long as there is agreement on a voluntary basis all will be well. However if an agreement is not reached there may be very negative consequences for the markets. Although the Greek bond market is small the impact of a disorderly default may lead to higher bond yields in places like Italy and Spain, and a setback in global risk assets such as equities. Equity markets could fall up to 10%. Our advice is to remain mindful of the ongoing risks.

In our own portfolios we added to equities some weeks ago but are not in any rush to chase the markets. However we continue to look to buy into significant dips. Our preferred markets remain Japan and the Euro zone however we stress these are very tactical views for short term
trading.

In fixed income markets with US 10 year bond yields still hovering around 2% we suspect that more and more investors will look to higher yielding bond markets. We continue to be struck by the gap between yields in the US and other highly rates paper in the MENA region. US 10 year yields are around 2%, Qatar bonds on a similar credit rating trade on a close to a 4% yield.

In my recent conversations with international investors I am seeing more and more becoming aware of the value in MENA bond and sukuk markets and they are looking to invest.

Note: This is the CIO Weekly Economic Review for January 26, 2012 - by Gary Dugan, Chief Investment Officer, Private Banking, Emirates NBD.

About Emirates NBD
Emirates NBD (DFM: Emirates NBD) is a leading bank in the region. Emirates NBD have a leading retail banking franchise in the UAE, with 132 branches, 705 ATMs and SDMs. It is a major player in the UAE corporate banking arena, and has a strong Islamic banking, investment banking, private banking, asset management and brokerage operations.

The bank has operations in the UAE, the Kingdom of Saudi Arabia, Qatar, the United Kingdom and Jersey (Channel Islands), and representative offices in India, Iran and Singapore.

For more information about Emirates NBD, please visit www.emiratesnbd.com.

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