Since the ECB's actions limit the immediate risks of bank failure, the crisis in Europe may not end up inducing the feared large downside event. While we expect the euro crisis to remain contained, risks appear to be growing in China. Investors have bid up strategies to avoid large downside portfolio moves (S&P out of the money puts, commodities, and Treasuries), but have ignored risks to the consensus view that favors emerging markets over developed. Slowing growth in emerging markets means we favor developed markets for taking credit risk exposure, through monetary policy easing in emerging markets should benefit local currency emerging market debt.
With all the systemic risk fears centered on Europe and scenarios for "tail risk" dominated by Europe, a favorite aphorism applies: the shell you can hear is not the one that hits you. While we are concerned with "tail risk" scenarios, that is, the risk of large downside events for the financial markets, the current focus on Europe may not end up being the catalyst for such an event.
Why not? As a result of the European Central Bank's expansion of support for the banking system, Europe's problem now rests on long-term structural changes, not a short-term liquidity crisis. Fixing the latter by no means ensures the former will be adequately addressed: solving the liquidity issue is a necessary but not sufficient condition to "solve" the European crisis. Rather, the ECB's support for financial market liquidity — its liquidity "solution" — merely preserves policy makers' options, allowing the much longer process of fiscal consolidation to proceed. Protection against extreme downside risks are both popular and expensive as a result, most notably in S&P 500 downside put protection (out of the money puts), but also in the form of inflation protection (TIPS) and safety (Treasury yields). Hence, for the tactical outlook we favor shedding some of these safe haven assets.
Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities ("high yield" or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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