Turn on the printers or restore default settings?

Newton Investment Management Limited (Newton) is based in London, and recognised as a top-tier UK investment house, renowned for its distinctive, proven global thematic investment approach, consistently applied across all strategies.

Since the financial crisis broke in 2008, global economics has been dominated by one major theme, that of deleveraging. From the US, the UK and the Eurozone to the emerging economies, the world is currently in the midst of a multi-year deleveraging process. 2012 will no doubt continue to be dominated by the spectre of debt, with the authorities in the developed and developing economies tackling the challenge in very different ways. A backdrop of low and volatile economic growth, along with the combination of loose monetary and tight fiscal policy poses tough questions of economies set on debt reduction, but historically, such conditions also provide strong support for global government bond markets.

Stick or twist…

Deleveraging in such an environment is an unenviable task, given the ease with which an economy can flit between positive and negative growth numbers. For developed economies, the policy responses available are limited. For those countries that don't have control over their monetary policy or bond markets, the response is to pay less back, whether it be through haircuts on their bonds or even through defaults, approaches that are ultimately deflationary in nature. Meanwhile, in an effort to ensure that economic growth remains positive, others could go down the path of printing money and effectively devaluing their debt, especially if there is no scope to cut interest rates.

Historically, the countries that default tend to be those that are beholden to foreign demand for their sovereign debt, hence why it has traditionally been emerging economies that have defaulted in the past. Indeed, one of the problems with the structure of the Eurozone is that individual states do not have control of their own monetary policy. A sovereign default tends to lead to a period of negative economic growth, destruction of capital, and less investment, but we believe that the sooner it happens, the sooner the rapid and enforced debt reduction, and subsequent rebuilding, can take place. Meanwhile, if through the period of economic weakness there has been a devaluation of wages, the economy is likely to more quickly return to a state of competitiveness and begin attracting foreign investment once again. We need only look to the example of Argentina in the early 2000s to see that economies can emerge from sovereign defaults in a stronger position, despite the initial shocks to the system (see table).

In contrast with the deflationary nature of sovereign defaults, those economies in control of their monetary policy and with their money printers switched on, face creating a legacy inflation problem. However, in the short term at least, this approach is likely to mean less deflation given that while the banking sector is deleveraging, the velocity of money - the rate at which money is exchanged from one transaction to another - remains low and the printed money isn't levered up into the real economy. The focus of these countries remains on maintaining economic growth at all costs, but there will be downward pressure on their currencies as the printing of money effectively means the debasement of that currency. Regardless, given that economic growth is likely to be positive and the debt levels more stable, these sovereigns are likely to receive safe-haven flows. Furthermore, the stability of their currencies relative to others could come at a premium in the near term, although currency weakness is likely in the long term due to the effects of quantitative easing.

Policy flexibility

In terms of government bond markets, the UK, US and some of the 'core' European countries are, perversely, likely to be supported by their quantitative easing programmes given that they should be able to maintain positive economic growth, regardless of concerns about their own burgeoning fiscal deficits. Meanwhile, there is also likely to be appetite for sovereign debt issued by those countries that still have monetary policy flexibility, such as Norway and New Zealand, which are in a better shape in terms of their fiscal credibility.

Meanwhile, bond investors are likely to remain wary of those countries without the ability to maintain economic growth, and without monetary policy control, such as a number of the economies on the 'periphery' of the Eurozone, as well as some of the 'core' nations such as France, Austria and Belgium. Further afield, there are likely to be investment opportunities in those emerging economies which have the scope to reverse monetary policy, which has been tightened in recent years, in order to maintain and boost economic growth. This is the case across a number of Asian and Latin American countries.

The deleveraging story seems set to heavily influence investment thinking over the coming year. In such an environment, the means by which countries attempt to maintain growth is likely to prompt a fragmentation of markets. However, for global bond investors, this allows plenty of scope for diversification across a number of investment opportunities.