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Test of nerves

Investor nervousness in the risk markets will continue until there is much greater clarity

As each month passes, the volatility in all markets continues to escalate. There were a number of significant developments during August, all of which contributed to the turbulence.

The market finally pushed the ECB into intervening to halt the rout of Italian and Spanish government bonds but while its significant buying had the desired effect, it did little to convince the market that the fiscal deficit problems in these countries are anywhere near solved.

The market’s eye soon turned to developments in the US where, despite a last-ditch agreement to raise the country’s debt ceiling, S&P took the bold decision to downgrade the US credit rating.

The move had only a limited impact on the market for US government debt. However, the realisation that the austerity measures required to reduce the fiscal deficit would be a drag on economic growth for a number of years prompted a fresh bout of nervousness in all risk markets.

With this backdrop, the themes of gilt market strength and credit weakness continued to dominate during August.

Investment-grade credit spreads extended their general move wider, with the usual culprits of peripheral European corporates and anything financial feeling the brunt of the pain.

We made a number of small changes at individual stock level during the month. With market liquidity continuing to dry up, we looked for costeffective ways of taking advantage of some of the relative value opportunities emerging.

We identified a number of bonds that we felt had either significantly out or under-performed the wider market for no discernable reason. We reduced or completely exited positions in Old Mutual, Telereal, Tullet Prebon, Wales & West and International Petroleum Investment Company, among others.

Proceeds from these sales were partially used to fund purchases in Tesco Property Finance and Anglian Water as well as increase the fund’s allocation to gilts. Towards the end of the month, we closed out the senior financial CDS protection we had put in place during July.

Although we remain cautious on the outlook for credit markets, we felt the market had discounted a significant amount of bad news in a very short space of time and believed we may get an opportunity to instigate a similar position at more attractive levels in the coming weeks.

Until investors get much greater clarity and confidence on a number of issues, the current all-encompassing nervousness that characterises risk markets is set to continue.

The market still awaits a coherent response to the public debt crises in peripheral Europe. Its current preferred solution are eurobonds which have joint guarantees from all members of the monetary union. However, the idea is meeting significant resistance from within Germany, whose strength would be relied on to make such bonds a viable option.

It seems certain the market will test Germany’s commitment to the European Union to the absolute limit over the coming months. If the political will behind a united Europe is strong, it may end up having to accept things it currently finds unpalatable. However, the journey between here and there may not be a particularly pleasant one.

In the US, investors, especially in equities, seem to be pinning their hopes on Ben Bernanke riding to their rescue with a third bout of quantitative easing.

It is questionable whether it would be a case of diminishing returns with regard to its impact on the domestic economy. However, it would undoubtedly be a fillip for risk markets, at least in the short term. The market awaits the outcome of the Fed’s extended meeting later this month with bated breath.

If all the above sounds somewhat bearish, it is worth reminding yourself that with the recent weakness, the market has priced in a very pessimistic outlook. Indeed, yields and prices on specific bonds caught in the eye of the storm are approaching levels not seen since the dark days of late 2008/early 2009.

Iain Buckle is fixed- income fund manager at Kames Capital

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