As I speak with our clients from more than 20 countries across the globe, I am struck by one pervasive similarity: nearly all are considering dramatic changes to their asset allocation strategy.
The catalysts for change are weak yields and weak total-return projections for traditional fixed-income markets. While each recognizes that fixed income is a critical source of return stability, ultralow yields in traditional markets make it increasingly difficult to achieve overall return targets in the 7% to 8% range. Most analysts project G4 bond benchmarks (U.S., Japan, Germany and U.K.) will return somewhere near 0% to 1% during the next few years. To maintain fixed-income allocations and also meet high return targets, investors must adapt by increasing their bond manager's flexibility to allocate globally and asking managers to generate greater alpha through unconstrained mandates.
This market trend toward globally flexible fixed-income investing partially reflects a natural response to yields that you have to squint at to see in traditional G4 bond markets. G4 bond markets are historically expensive because pessimism, deleveraging and central-bank manipulation have defined market action for years now. But while these sources of supplemental demand have benefited G4 bond market returns in past years, much of that demand could evaporate if global policymakers are successful in creating an environment that fosters self-sustaining economic growth.
Unlike the global economic forecasts of the World Bank and the International Monetary Fund, we see good reason to expect a pickup in economic growth in 2013 — precisely why we view G4 bond assets as currently offering little value for investors. The combination of low absolute yields and accelerating economic activity creates a high probability that G4 bond markets will deliver negative absolute returns in the coming years. Think about this for a moment, the monetary policies of the G4 are very potent and designed to create economic success following one of the most impactful financial crises in modern economic history. What will happen if the central banks succeed?
Why do I think the chances of policymakers succeeding are higher in 2013 relative to past years? For a long time we have been making the statement that leadership matters. Where will it come from and who will it be? Well low and behold, the bold and impressive leadership that we were looking for appeared in the most unexpected places in 2012 to create a strong global momentum for financial markets and economies. Last year, Mario Draghi, European Central Bank president, cut through politics and traditional Bundesbank rhetoric to bring the eurozone back from the brink of collapse — first in providing liquidity to the banking sector through longer-term refinancing operations and then by committing to saving the euro in July. Then Japanese Prime Minister Shinzo Abe returned to the political scene after a multiyear hiatus with a bold plan to stop Japan's chronic deflation. This breath of fresh air is sweeping away the political gridlock that was organized around a policy that confused low interest rates with reflation. What is fascinating is that Jean-Claude Trichet, the prior leader of the European Central Bank, suffered similar misperceptions.
So in 2012, the global economy benefited from the actions of two new leaders who demonstrated strong will to generate economic success. Prior to 2012, pockets of policy leadership existed, especially in the U.S., but only now does strong leadership arguably exist across all systemically important economies. Moving forward, Europe won't be a source of confidence-sapping volatility and might be a source of economic growth.
After the achievements of 2012, we don't believe that policymakers will stop taking bold actions designed to jump-start economic growth. Investors were so worried about tail risks prior to 2012 that investment fundamentals were generally pushed aside. For years, markets behaved chaotically and fundamentals meant little against the force of systemic risk. But in 2012,we made the decision to accept the simple thesis that policymakers would increasingly subordinate ideological purity to goals of self-preservation through reflation. That simple thesis was a great compass to use in 2012. Central bankers proved once again they are all powerful. But with most all effects related to monetary policy, the effects work with a lag.
Successful investors will position themselves to exploit the likely upcoming policy success. If you believe policymakers are determined enough to continue winning the war of confidence, why have exposure to overvalued G4 markets? Benefit from better sources of yield around the world that will command investor demand in an improving world.
Investors should look to own assets in the bond markets of countries with yields that better reflect the stage of the business cycle. Currently countries like Mexico offer attractive risk-adjusted return potential with short-term interest rates at 4.5% and long-term rates at 5% to 6%. These rates are compelling even after accounting for roughly 3% inflation. Moreover, the Mexican sovereign offers a better debt-to-GDP ratio than G4 markets, a better fiscal position, and a better trade balance.
Even without taking duration risk, many countries offer short-term yields that are very attractive. Countries like India, Turkey, Brazil and Russia, for example, all provide short-term yields around 7%. These countries' central banks are diligent on keeping inflation in check and, therefore, typically maintain policy rates above the rate of inflation — something even longer-term bond yields in G4 markets do not provide.
The opportunities in global markets are broad and diverse, allowing a manager to express a nuanced and deliberate perspective on market risks. We believe G4 duration is one of the risks that investors would be wise to fade in 2013. Instead, by making the entire world your bond universe, you can achieve a high quality and benefit from diversification effects because different countries around the world are at unique points in the business cycle.
Stephen S. Smith is a managing director and portfolio manager at Brandywine Global Investment Management.
