Credit markets may have been too pessimistic

Beyond the noise generated by the European sovereign debt crisis and the seemingly unending debate about reducing the U.S. federal fiscal deficit, we believe macroeconomic fundamentals are evolving just as they might be expected to in the wake of the financial crisis of 2008-2009.

It is useful to remember that the U.S. grew at an (admittedly not spectacular) annualized rate of 1.8% in the third quarter of 2011.5 Given this continued growth in the U.S., spread widening in recent months suggests to us that credit markets globally are possibly being too pessimistic about economic prospects in the U.S. and around the world.

The Organisation for Economic Cooperation and Development in late November forecast that Europe was likely to suffer, at worst, a mild recession in the final quarter of 2011 and the first quarter of 2012 and that the U.S. would continue to grow at a real annualized rate of 2.0% to 2.5% in the same period.

Given this moderate growth and given that quantitative easing initiatives by central banks (essentially involving bond purchases through newly minted money) may help spur inflation, we believe current benchmark government bond yields in countries such as the U.S. may be too low.

The “real” yield—the difference between 10-year U.S. Treasury yields and the inflation rate—went as low as -1.92% in September (its lowest since at least 1992)6 and still stood at zero at the beginning of December. In other words, investors have been willing to lend the U.S. government money for 10 years with the expectation of being paid zero interest in inflation-adjusted returns.

By contrast, we regard debt sold by industrial companies in Europe and the U.S. as attractive, especially as spreads (the extra yield investors demand for company bonds worldwide instead of similar-maturity government debt) had widened to 277 basis points by end-November, according to the Bank of America Merrill Lynch Global Broad Market Corporate Index.

And yet 70% of Standard & Poor’s 500® Index companies beat analysts’ consensus forecasts for third-quarter earnings, according to data compiled by Bloomberg, while the default rate on noninvestment-grade debt was well below the longer-term average. We believe the possibility of continued growth of the U.S. economy should be positive for corporate bonds even if profit growth slows.

Although slowing, China’s growth could be in excess of 8% next year, and the country, along with most Asian nations, has fiscal scope to potentially cushion its economy from any further escalation in Europe’s debt crisis, according to a World Bank report in late November.7 We believe the rest of Asia should likewise be able to withstand the blows from any slump in demand for its exports or pull- back in credit by European banks.

We, therefore, continue to believe that local and foreign currency-denominated debt issued by some emerging Asian countries, including the likes of Indonesia, offers value for global bond investors given the region's strong fiscal positions and economies.

Federal and state debt in Australia also looks attractive to us, and, despite an interest rate cut by the Reserve Bank of Australia at the beginning of December, we think the Australian dollar offers scope to potentially push higher once the fear of a hard landing in China recedes.

While we expect the euro to survive, eurozone leaders need to present a credible plan that allows them get ahead of the market on the sovereign debt crisis. The Brussels summit in early December represented another attempt to do just that, but it remained unclear to us at the time of this writing whether the markets were willing to accept at face value the stated commitments to deeper fiscal integration and much closer supervision of national budgets. We have been avoiding debt issued by the European Financial Stability Facility, the eurozone’s bailout fund, just as we have remained cautious about eurozone government debt for some time.