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Variations on a theme

Five main themes help to keep pace with a seeming grand old duke marching funds up the hill and down again

Perhaps it is the impact of a young child in the house but when I consider the current market environment, my thoughts turn to the Grand Old Duke of York. As markets march upward, only to march all the way back down again, it can seem as if they are being commanded by a whimsical old duke rather than invest-ment fundamentals.

This poses a problem for investment managers. We spend the majority of our time seeking to make a rational assessment of assets’ true value. Whenever the market marches back up the hill, pushing corporate bonds and equities higher, we tend to think it is moving closer to where we think funda-mental value lies.

However, a throwaway remark from one of Europe’s armies of policymakers could trigger an about-turn at any moment. A number of quest-ions remain to be answered about the latest “compre-hensive and global” rescue package. How will the leveraged EFSF work? Will the deal give investors sufficient confidence to resume buying Italian and Spanish debt? Should Europe hit a nasty recession, will a tier-one capital ratio of 9 per cent be enough? And what will be the impact of the seeming political meltdown in Greece?

Those unanswered questions mean that vola- tility is likely to remain with us for the foreseeable future. We are sticking to our them-atically-driven investment approach, which we believe will steer a steady path for the Swip strategic bond fund. In order of importance, our current main themes are:

  1. Volatility. This seems likely to remain elevated. Given this, we are focusing more on stock-specific trades and less on daily gyrations in the wider market. We concentrate on trying to capture outper-formance without taking too much risk. As an illustration, we might increase allocation to specific high-yield bonds but reduce its market exposure (beta) through buying a derivative index.
  2. Positive surprises on the US economy are likely, Europe may continue to disappoint. We remain positive on the outlook for the US economy. There are tentative signs that the housing market may finally be nearing a floor and poised for a recovery. It is also notable that consumer spending has remained level, so we prefer bonds issued by companies whose focus is on the US domestic economy rather than Europe.
  3. European crisis. This one will run and run. It is in Europe that we see the biggest gap between the valuations indicated by fundamental analysis and current market prices. Even if we allow for a severe recession and a subsequent rise in default rates, our core view is that high-yield bonds are cheap and offer an excellent return.
  4. Inflation. Central banks in the West are printing considerable amounts of money and are likely to continue doing so. This will lead to inflation somewhere in the system, either in asset markets or in prices for goods and services. The question is not if but when.
  5. Rising yields on government bonds… and not just in Italy and Spain. When the sharp rise in government yields does eventually arrive, it will no doubt seem obvious in retrospect that gilt yields were in bubble territory. Timing, of course, is everything.

By combining these themes into specific investment ideas, we believe we can continue to achieve good returns. We have a long-term, positive view of corporate credit and a far less positive view of government bonds. In the short term, however, we recognise that – much like a soldier in the employ of the Grand Old Duke – we will need to remain on our toes.

Luke Hickmore is investment director of fixed income at Swip


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