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How to play the return to growth through bonds

How to play the return to growth through bonds

As we move into 2013, market focus is likely to shift increasingly to growth. Will the real economy pick up momentum? The IMF estimates global growth to finish up around 3.3% this year, with growth prospects expected to tick up modestly to 3.6% in 2013.

While this growth rate sounds appealing, it is a worldwide average that hides a high level of disparity between the developed world (IMF estimate 1.5%) and developing countries (IMF estimate 5.6%). A number of factors are capping growth potential going into next year as developed countries’ deleveraging continues. Recent industrial production numbers in the US and the eurozone illustrate the magnitude of the challenge that lies ahead.

Some industries in the Western world are in structural transition and in the process of adjusting to increased globalisation. The auto sector, for instance, is dealing with a raft of capacity reductions across Europe. The steel industry is also feeling the pain as growth is focused on emerging markets, and these are required to consolidate. Another field in transition is the financial sector. Banks are still licking their wounds following the financial and subsequent sovereign crises.

The fiscal picture across the West remains unstable and subject to change, complicating corporate and private economic planning. The general trend across the board is consistent: governments on the whole are looking to increase their level of revenue. The ‘when, how and where’ this is done generates uncertainty, causing postponed investments, delayed hiring and other unintended consequences. These negative effects are further amplified by the number of countries looking to adjust at the same time. As a result, the fiscal multiplier is likely to be higher than historical trends suggest.

Developed world unemployment levels remain historically high. In the US, while the trend is now positive, unemployment levels peaked in September 2009 at 10% and have since been declining to reach 7.8%, but the absolute level remains historically high. In Europe, unemployment has reached a record of 11.6% and is likely to continue to increase in months to come. This puts pressure on consumer sentiment and reduces capacity and willingness to spend.

Banking sector lending standards in Europe are tightening according to recently published surveys. Banks are still suffering from the fall-out of the sovereign crisis and its effect is compounded by regulatory changes, reducing risk appetite and increasing the cost of capital.

On a more positive note, however, a number of sources of growth have the potential to counterbalance this rather gloomy picture.

Developing markets are continuing their expansion at a decent clip. Middle classes in Asia and Latin America are expanding, benefiting the consumption industry be it in beverages, retail or luxury goods. Global auto sales are back to pre-2007 levels, driven by growth in emerging markets. Luxury brands in particular continue to benefit from these trends.

The US deleveraging cycle is well advanced. The housing and construction markets seem to have reached a floor and are showing signs of growth, albeit from a low base. This is starting to show in the earnings of construction-related companies with exposure to the US market.

Even though funding remains difficult for smaller companies, cheap money is readily available for large corporates in the US and core Europe. All in investment grade corporate funding levels average between 2 to 3% in the medium term.

Uncertainties around the fiscal cliff and debt ceiling in the US as well as the Eurozone have delayed spending and potentially stored pent-up demand. Once more progress is made on the fiscal front and corporate visibility improves, this pent up demand could provide an additional boost to growth.

A number of sectors in the economy are benefiting from a supportive growth environment due to increased urbanisation, technological progress, environmental awareness and regulatory changes. Cable players continue to gain ground and sell higher value services. Mobile providers will be looking to profit from faster mobile applications brought by the deployment of 4G. A number of sectors are benefiting from innovation driven by a need to reduce reliance on energy commodities. Transport services are looking to renew fleets, keeping order books solid for civil aircraft builders. Emissions regulations, while a cost for auto builders, are providing lucrative sources of revenue for auto part manufacturers.

While overall growth prospects remain finely balanced, the confirmation of the recent improvement in the US economy could lead to strong momentum for next year and drag up the overall growth rate. On the other hand, China could disappoint and subdued growth become the norm as central banks remain vigilant to downside risks. As a result, investors are likely to keep a balanced approach searching for yield but still wary of volatility.

Henrietta Pacquement is AA-rated manager of the European Credit fund.

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