@ a glance newsletter
Global growth – a new take on alphabet soup
(February 2010)
The ‘alphabet soup’ debate has raged since late 2008 and is likely to continue well into 2010. This debate refers to the letter of the alphabet most resembling the likely path of global growth following the global financial crisis. Can we expect a V, U, a W or an L-shaped recovery or sequential combinations of these? Examples of these outcomes can be seen below.
Taking a fixed income based approach to this debate brings interesting outcomes. For example, considering a U-shaped recovery for fixed income markets.
The attributes of this type of recovery for fixed income markets include wide credit spreads, along with stable cash and government bond yields. The main drivers of this outcome are the interacting forces of slower than expected growth, increasing government debt and low inflation.
Corporate profit margins would initially hold up due to cost cutting initiatives, but ultimately profits suffer as household savings increase to assist in the deleveraging process (the process in which debt is paid down). Investors’ total returns from government bonds would be low, while corporate bond returns would be moderate as wider credit spreads would make a significant difference to total returns.
In the case of a V-shaped recovery for fixed income investors, economic growth would be strong, leading to a quick return to strong growth. After cutting costs, companies would be left with an operating leverage (where earnings increases can flow through to profits due to low variable costs), meaning that a V-shaped growth profile would result in strong company profits. Central banks would therefore need to normalise cash rates, resulting in rising bond yields. It is likely that credit spreads would then narrow from the wide levels seen during the global financial crisis, providing an important balance where corporate bonds would be superior to government bonds.
In Australia, it can be argued that corporate bond investing gives the best of both worlds. Investors are able to access U-level credit spreads with V-shaped government bond curves, relative to fixed income markets in other countries. Australian government bond yields are currently high compared to international bond yields. This is because Australia’s cash rates did not fall as far as they did around the world and our central bank has begun raising interest rates. This suggests the yields on Australian government bonds have already priced as if we are in a V-shaped recovery. In AMP Capital’s view, this translates into the potential for a great investment backdrop for Australian credit investors.
