Investing in fixed income in uncertain times

This article originally appeared on benefitscanada.com

As 2012 comes to a close, what’s the outlook for fixed income and equities in the coming year?

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With no relief for volatility in sight, investors should think about buying volatility—both globally and in the U.S.—in an effort to ride out the fluctuations in the market, said Patrick Maldari, senior portfolio manager, fixed income at Artio Global Management, at a presentation in Toronto earlier this week.

He also projected growth in the U.S. will remain weak in 2013. “We believe growth will stay in the 1.5% range,” he said.

The reason? “There is too much debt at the individual, corporate and government levels,” he says. “The debt as a portion of GDP is 350%. The U.S. has a long way to go.”

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The low rate of growth has an impact on the rest of the world, as well as profound implications for portfolios; slow growth should continue to put pressure on the U.S. Federal Reserve to maintain 0% short-term rates.

To build yield into their portfolios, investors will be forced out on the risk spectrum into non-Treasury-related sectors such as high yield.

But Maldari says he currently sees value in a number of areas, including B-rated securities, European high yield, emerging market corporate debt, loans and Canadian high yield.

Concerns for equities

On the equity side, Brett Gallagher, deputy chief investment officer and senior portfolio manager of equities with Artio, notes there are four areas of global concern that will affect long-term equity returns:

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• Japan – The country’s debt as a percentage of GDP is 250%. While historically, 95% of that debt has been bought by Japanese households and corporations, who’s going to buy the debt Japan has to sell as the population continues to age? Japan will struggle to keep interest rates down and will likely be forced to engage in a quantitative easing of its own, which should cause its currency to weaken over the coming years.

• Emerging markets – A lot of investors fled emerging markets this year over worries of slowing growth in China, he says. But over the last 10 years, emerging markets have dramatically increased their share of global GDP from below 20% to near 40% today. The likely driver of continued share growth will be rising incomes and urbanization, particularly in China and India, he said.

• Europe’s solvency – Although everyone knows about the debt problem in Europe, what is not as well known is the competitiveness issue, said Gallagher. German unit labour costs have gone up only 4% since the euro was introduced, versus 20% to 40% in other countries, leaving many of them uncompetitive within Europe.

In addition, the authorities have made little distinction between solvency and liquidity—Greece is not solvent (it can’t meet its obligations). However, Italy has a liquidity issue. It has large amounts of debt, but it also has a primary surplus (meaning before interest payments). Unfortunately, about one-third of Italy’s debt matures in the next 15 to 18 months, leaving it vulnerable to rising rates, he said. Down the road, then, Italy could turn from a liquidity problem to a solvency one unless Greece is dealt with quickly.

• U.S. imbalances and outlook – The U.S. has a greater pile of debt, growing faster than the all of the European countries put together. “Any country that lives beyond its means,” said Gallagher, “there will eventually be a day of reckoning.” Rising rates could force the issue by causing debt service costs to explode.

Despite these challenges, Gallagher says investors should remain focused on long-term return expectations, which can be reasonably estimated. Short-term equity projections are very unreliable and based on near-term news headlines.