Week 45/2011: Ground Zero Shifting from the Periphery to the Core

Summary:

Italian 10-year yields hit 7% last week; Spanish yields broke 6%, while French government bond yields are now 3.5%, a jump of 50 basis points since the start of the month. This trend is unsustainable. Meanwhile, a window is opening for Irish DB pension schemes to lock in an improvement in their respective funding levels as core bond yields rise. The model portfolio returned +0.4% last week. Equities gained +0.3%, bonds fell -1.3% and gold in euro terms added +2.3%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio has returned +0.7% compared to -5.0% for the Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

DJIA	12,134	Dollar Index	$76.95	CRB Index	320.20
DJTA	4,978	CAD/EUR	1.3890	Gold	$1,789
DJUA	453	USD/EUR	1.3750	Silver	$34.70
NDX	2,679	JPY/EUR	106.10	Copper	$3.48
S&P 500	1,264	JPY/USD	77.20	Oil WTI	$98.90
ISEQ	2,697	USD/GBP	1.6065	Natural Gas	$3.58
FTSE	5,545	10 Yr. Tsy.	129.80	Soybeans	$11.85
Nikkei	8,514	30 Yr. Tsy.	140.45	Corn	$6.55

Headline news events continue to roil the markets. In the last week alone, both Papandreou and Berlusconi have fallen on their swords; a botched referendum attempt ended the Greek Prime Minister's reign; the bond market killed Berlusconi, as Italian 10-year yields breeched 7% for the first time. Despite the daily surges and plunges, most equity markets finished in the black last week, barely. In Europe, we continue to see losses.

The good news is that equities are holding up rather well, despite the recent surge in bond yields. If this trend continues, and I expect it will until February/March of next year, it could prove to be quite a positive development for Irish defined benefit schemes. In fact, the funding position of the average Irish pension scheme improved considerably last week from 74.3% to 79.9%, on the back of a 30 basis point increase in 20-year French government bond yields from 3.8% to 4.1%. So, as contagion spreads from the periphery to the core of Europe, there may be an opportunity for Irish pension schemes to take advantage of the unfolding crisis.

The endgame has well and truly begun and the Germans will be forced to make a very difficult decision over the next few months: continue on a path of trying to force multi-year austerity and debt restructuring across the Eurozone or crank up the printing press. If Germany and the ECB say no to the latter, then they must agree to the former. If the printing press option is not used and the debt default option is ignored, sovereign bond yields of all Eurozone members (ex Germany) will continue to climb and climb until we reach a crisis point. This appears to be the strategy at present. We are running out of time. The trend in yields is unsustainable and a result of countries simply carrying too much debt. How much debt? Adding government, corporate and private sector debt together, the average OECD country is carrying a total debt burden of over 300% of GDP, and these were based on 2010 figures!

If Germany attempts to follow the debt default/austerity route, there is another problem. Rolling debt defaults across the Eurozone will implode the European banking system. In the next table, you can see the level of inter-connectedness between the European banks. Data from the Bank for International Settlements (BIS) show that the German banks hold approximately $1.65 trillion of EU sovereign debt on their balance sheets. In France, the exposure is similar. French banks hold $1.69 trillion of EU government bonds. France has a huge exposure (relative to all other countries on the list) to both Italy and Greece. Even the US banks hold $1.7 trillion of European sovereign debt; for UK banks, the number is a little lower at $1.06 trillion. Austerity and debt restructuring cannot work. The banking system wouldn't survive. Money printing is the only viable solution and it needs to happen quickly.

As noted above, despite the crisis in government bond markets, the outlook for stocks is still positive. From a technical perspective, we broke long-term support in August but regained the rising trend in early September. The primary trend continues to support a bullish outlook for stocks. Maybe the stock market already knows that money printing will be the agreed solution and is rallying in anticipation of that outcome.

BONDS:

The current term structure of interest rates for the German, US and UK government bond markets are summarised in the following table.

Current Yields	German Bunds		U.S. Treasuries		U.K. Gilts
3-Month	0.16%		0.01%		0.46%
2-Year	0.34%		0.23%		0.49%
5-Year	0.92%		0.92%		1.09%
10-Year	1.80%		2.07%		2.20%
30-Year	2.50%		3.14%		3.20%

The Asset Allocation Team currently maintains the following fair value yield estimates for 5, 10 and 30 year government bonds for the French, US and UK fixed income markets:

Fair Value Yields	German Bonds		U.S. Treasuries		U.K. Gilts
5-Year	4.30%		4.40%		5.30%
10-Year	4.40%		4.50%		5.30%
30-Year	4.40%		4.50%		5.30%

Government bond yields remain significantly below the fair value estimates of the Asset Allocation Team, particularly for 5 and 10-year government bonds, hence the continued bearish view on this particular asset class. 

MODEL PORTFOLIO:

The model portfolio returned +0.4% last week. Equities gained +0.3%, bonds fell -1.3% and gold in euro terms added +2.3%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio has returned +0.7% compared to -5.0% for the Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

TOP TEN INVESTMENT IDEAS FOR 2011:

	Top 10 For 2011	28/01/2011	Comment
1	Long Gold	$1,337	Conservative inflation hedge
2	Long CEF.A	$18.95	ETF backed by 50% gold, 50% silver
3	Long NEM	$55.00	Miner leveraged to rising gold prices
4	Long EGD	$4.20	Mining services company that sells equipment to the sector without taking the exploration risk.
5	Long GDXJ	$34.60	Junior miners ETF – when gold hits bubble territory, GDXJ will best capture the mania that follows.
6	Short 30 Yr Treas.	$121.45*	28 year bond bull market over, with US 10-year yields troughing at 2.4%.
7	Long MSFT	$27.75	The cash machine of the technology sector; single-digit P/E with double-digit EPS growth.
8	Long CAD/ Short JPY	JPY 82.00	JPY must decline so Japan can regain competitiveness and reduce its massive debt burden (200% of GDP).
9	Long Sugar	$0.34/lb	Commodity play with strong supply/demand imbalance
10	Long Soybeans	$14.05/ bushel	Commodity play with strong supply/demand imbalance

* Incorrect price listed in week 4 update and amended above.

YTD PERFORMANCE OF 2011 BEST IDEAS:

PERFORMANCE OF 2010 BEST IDEAS: