Over recent months ‘bond vigilantes’ have demonstrated to politicians what real power looks like, bringing Greece and other European fiscal miscreants to account. The central issue is the solvency of governments, typically regarded as safe ‘lenders of last resort’, and is profoundly more complex when it relates to 16 members of a single currency. Any resolution will involve some members ‘winning’ and others ‘losing’, a very different political equation from the relatively benign environment of the early years of the euro. This drama will be long-lasting and far-reaching, needing to address the solvency of both governments and banks. How harsh will the required write-downs of sovereign debt be, or how robust are the capital ratios of banks? The s750bn bazooka fired by the IMF and European Central Bank has bought some time, but has not resolved any of the fundamental issues.
The wider issue for investors is whether fiscal tightening in Europe and elsewhere will prematurely choke the momentum of a nascent global recovery. While the balance of risks has clearly shifted, there is momentum behind both the US and Asian recoveries, with ample liquidity and the prospect of sustained low interest rates to support them. The stakes are high – the US must maintain its historic role as the prime engine for global growth and China’s role in setting the pace in Asia has never been more critical. Tension about the outcome – ‘double dip’ or sustained recovery – is evident in many ways and most obvious in the debate between deflation proponents and those who argue that inflation is the greater threat, a theme picked up by Carl Astorri in this quarter’s ‘Global Perspective’.
While happy to grant the US some ‘extra time’ during the current pressure on euro members, the bond market will at some point also demand that the US puts its fiscal house in order. This threat explains the pre-emptive fiscal consolidation delivered by the new British government late in June. We believe that high-quality corporate debt is where investors will find value in global bond markets, not sovereigns, a theme detailed by Stefan Muheim in a feature article in this issue.
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