Thrifty Investing
Global Bond and Currencies

Market sentiment has switched from the fear of a Depression to the expectation of a prolonged period of economic weakness (and even to suggestions that there are 'green shoots' of economic recovery).Meanwhile, the safe-haven demand for government bonds has waned, but zero interest rates and quantitative easing (QE) have slowed the rise in yields in the face of a bounce in the prices of risk assets. To highlight this change in attitude, you only need look at the European high-yield market, which is up over 16% so far this year despite the reality of high defaults and notwithstanding a lack of funding alternatives for these highly leveraged companies.

Despite the bounce in the prices of risk assets, underlying economic problems remain. With very wide output gaps and rising unemployment, we expect inflation to decline significantly from here. As a result, we expect the market to refocus over the coming months on the weak economic backdrop and we anticipate that this will prompt another government bond rally.

Leaving aside the short-term 'noise' in markets, what are the long-term opportunities? They are falling into two connected areas.

1) Government bond markets are likely to be 'managed' by the authorities as the public-sector debt burden weighs on the market. This debt burden offsets the writing-off of debt in the private sector and the process keeps inflation low (but also serves to keep potential investment returns low). A prolonged period of thrift is what is required to recover from the wealth destruction from the credit crunch. Savings rates are rising fast in those countries that have previously gorged themselves on debt. In such countries, governments have to step in to maintain growth which ultimately leads to lower productivity. Higher savings rates are also a source of demand for government debt and should be beneficial therefore for government bond investors.

Having got into this mess because of an increase in private sector borrowing, we now need to adjust to the new world of private sector thrift and public sector borrowing. Rising savings rates in the West are now the norm, and their negative implications for economic activity (rising savings rates imply lower spending rates) are a real threat to the long-term sustainability of recoveries.

Public sector spending is not very efficient and takes time to lead to higher tax revenues. Expanding budget deficits are only partially a sign that governments are stimulating economies; they are more suggestive of lower tax revenues and lower profits. Also, governments do not apply leverage to their borrowings, but they are able to borrow at lower rates than the private sector. They can heavily influence the borrowing rate by maintaining zero interest rates and by printing money to buy bonds (QE). Even if a sustained economic recovery is well on the way, the last thing that recovery needs is a rise in the cost of government borrowing. Our more government theme explores these negative growth implications. More government involvement in an economy usually lowers productivity and reduces investment returns.

2) The second element is the growing discussion about the long-term future of the global financial system and its reserve currency. Clearly there will be growing calls to change the Anglo-Saxon model and these calls are coming at a time when the balance of wealth is shifting from West to East. This makes China's comments about future reserve currencies much more interesting than before. Also, in the Middle East, which is the other region with huge reserves, there are more noises about changing currency links.

The credit crunch and the resultant bounce in the dollar could mark the final swansong for the US currency and bring about its fall from grace as a store of value and a medium of exchange. By contrast, authorities are likely to be mindful that there is no viable alternative to trading in commodities except the commodities themselves. Whenever commodity prices fall in dollar terms, those countries that can stockpile commodities should do so. For an expanding economy, stockpiles of copper and steel are a much better store of value than 'fiat' (government-authorised) money. This is ultimately beneficial for commodity-based countries and their currencies, especially if they have better monetary and fiscal firepower than the beleaguered, debt-laden Western economies. The long-term economic potential of the West will be unfulfilled for years given high government debt levels and the necessity to save. Meanwhile, there are other markets which have had more prudent fiscal policies and this gives them a head start. The shift out of the safe-haven currencies (the US dollar and the yen) has begun and may run for a good deal longer. The inflation consequences from declining currencies in the indebted West will be negated by the ongoing demand destruction resulting from the move to thrift.

The two currencies that have been strong during the crisis, the US dollar and the yen, will be vulnerable in the recovery phase. The global recovery may still be a long way from here, but it is still worthwhile picking currencies that are undervalued and have sound survivability credentials.

The major currencies (the yen, the euro and the US dollar) remain the ugly three and are likely to underperform a variety of other currencies. Our global bond strategy currently has 30% of its currency exposure to this 'other' currencies bloc. The US dollar could lose its status as a world reserve currency and we anticipate a diversification away from the US dollar and into other commodity-based currencies. We will actively seek opportunities that arise from this diversification.

In summary, over the next few months we expect government bond markets to bounce back as inflation falls. After an initial setback, other bond markets, such as good quality corporates and emerging-market bonds, should be supported by the decline in government yields and by the prospects for an economic recovery later. In addition, a long-term shift out of the US dollar (and the yen) and into a variety of commodity-based currencies should enhance returns.