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Clinging on to the cliff

At the time of writing, the news was that Greece will get a government of national unity. Mr Papand-reou’s political reign is coming to an end and we should see the new coalition ratify the second bail-out package.

The Greeks have enough cash to see them though until mid-December, so they have a little time to sort out the mess. However, the situation is very fluid. Greece is still very broken. The bail-out package must still go through the new government and the bailout package is only a sticking plaster. What about the underlying social and welfare reforms?

The market is now scrutinising Italy. Italian bond yields continue to spike and the situation in the world’s third-biggest bond market is now looking seriously worrying. This is despite Silvio Berlusconi’s departure being welcomed by markets but it does little to address the real problem for Italy – a lack of growth in the economy. Italy has over €300bn to refinance in coming year, so the cost of its total debt service is rising at an extortionate rate.

Meanwhile, the European financial stability facility remains friendless, with not a single G20 country chipping in, and the relaunch of its €3bn 10-year deal met with a muted response. As a result of all the above, we are seeing more demand for US treasuries, gilts and bonds and a sell-off in risk assets and peripheral debt.

’A number of headwinds remain that continue to plague the market – Europe, soft data, inflationary pressures, to namebut a few – and we expect further volatility ahead’

Mixed economic data also appears to be supporting government bonds. By way of example, US non-farm payrolls came in below expectations and PMI data was very poor. Italian services data plummeted and EU-wide services also showed an aggressive contraction.

One thing is clear, however – Italy and the eurozone can ill-afford a recessionary environment right now. It is a bit of an understatement but we see few green shoots at the moment. In this environment, the Nordics should also provide a safe haven, although watch out for those speculative vultures swooping around peripheral debt.

For the second week in a row, the bids into the Bank of England reverse auction were very significant. This highlights the increasingly technical buying that is driving corporate spreads.

So far, this has resulted in buying on weakness, and putting aside the political situation for one moment, the amount of cash that investors have built up will support markets in the medium term. However, despite the global malaise, UK corporates are holding up well.

It is a different story in financial bonds, which are on very tidy double-digit yields. There has been a clear weakening trend, but in our bond portfolio we remain overweight financials and insurers. This means yield spreads remain at attractive discounts versus historical levels and non-financials, as well as in bonds with short call dates.

We have used the recent weakness to add to some of our AAA supranationals in order to add to duration, although these have also come off in recent days. We have also been slowly putting cash to work in existing positions.

A number of headwinds remain that continue to plague the market – Europe, soft data, inflationary pressures, to name but a few – and we expect further volatility ahead. Indeed, for now, we see markets continuing risk-off, yet desperate for chinks of light.

We are therefore building cash with a view to reinvesting in more credit when we see some light at the end of the eurozone tunnel.

Greece is hanging over a cliff, Italy is not far behind and Portugal is watching nervously. Disorderly defaults have only been postponed.

Julian Chillingworth is chief investment officer at Rathbone Unit Trust Management

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