Investors exposed to US financial assets have enjoyed reasonable certainty over short-duration exposures and a lot of question marks regarding the long-term outlook.
But even that modicum of confidence, regarding one-year Treasury bonds, could become a point of concern if American politicians don’t address a looming “fiscal cliff” at the end of 2012, says Jeffrey Rosenberg, New York-based chief investment strategist for fixed income at BlackRock.
Following the election, Congress is mandated to cut $1.2 trillion in discretionary spending, the Bush-era tax cuts on the rich will expire, cuts to payroll taxes (contributions to Social Security) will expire, and unemployment benefits will be reduced. Congress can amend or stagger these actions, but no action is expected until after the election, leaving a lame-duck session a tight window to compromise before the fiscal hammer falls.
This could jeopardise the short-term outlook for global investors with US financial exposures. Since the Federal Reserve embarked on monetary easing to stimulate the economy, investors have been able to confidently assume that, over a one-year outlook, interest rates aren’t going to rise in any dramatic fashion; therefore the risk of a loss of principal is small.
But the longer investors extend their duration, the less confidence they can have, and anyone holding 10-year Treasuries to maturity will surely face capital losses due to future rate hikes, as well as losses in value against future inflation.
Interest rates today are at record lows partly because of Fed QE and because the private sector continues to deleverage, creating surpluses in mortgage, consumer and corporate debentures.
Rosenberg says this situation could change in late 2012 or early 2013 because the United States’ fiscal policy is going to face abrupt austerity – which means a decline in GDP growth. This leads to questions about how big and fast could this decline be, and to what extent it will spill into bond markets?
“The market isn’t focused on this right now, but it may focus on the ‘fiscal cliff’ in the second half of the year,” Rosenberg says.
In particular, the fiscal cliff could mean trouble for risk assets within fixed income, which traditionally include credit risk, such as financial institutional debt and lower-quality asset-backed securities.
Depending on how markets react to US politics in the wake of the November presidential election, risk aversion could spread to equities and higher-quality corporate bonds.
Rosenberg says he does not expect a panic to materialise “if it’s in the price”, although the firm will reposition its portfolios if it feels the market has become too complacent.
Joel Kim, managing director at BlackRock in Singapore, says Asian fixed income offers the best protection against the longer-term risks in US and European sovereign debt.