1. Income & Fixed Interest
commentary
May 2012
May saw a continuation of the bond rally that started in Chart 1: US 10-year treasury yield
mid-March as the European crisis lurched further towards
the abyss. In the main developed markets bond prices
have moved steadily higher over the last few months (our
favoured markets of Germany and Australia were the
strongest performers this month) while peripheral bonds
suffered.
The moves in March saw yields hit new all-time lows
within a number of markets and yet we remain pretty
much max long in bonds here and are convinced yields
have much further to fall. In terms of performance, we
had another strong month in May with all funds
significantly ahead of monthly targets. In fact, it was the
strongest month since inception for our Pure Alpha Fixed
Income Fund, a very pleasing result given the event risk Source: Bloomberg
dominating markets right now. Our internal tracking
numbers indicate our Australian peer-group has had a It’s always mentally tough in environments like these to
rough couple of months, and now show us mid Q2 year- manage bond portfolios; to run bullish positions, as we
to-date and back at the top of the rankings on a rolling have done, means you are bearish on the global
one-year basis. economy and will profit as the world suffers. A friend of
At the risk of labouring the point we can't understand mine said to me last week that outperforming in these
portfolio managers who run massive short duration conditions is like winning on the card tables on the Titanic
positions relative to benchmark saying they are trying to – you are happy to be making cash but it's obvious that
preserve capital. In our view if you invest in a bond fund everything is sinking around you. In that regard I have
with an underlying benchmark (other than cash) you are always tried to be as pragmatic as possible: I try to control
asking your manager explicitly to manage to and the things I can and let go of the stuff over which I have
hopefully outperform that benchmark as you want that no influence. In terms of the long-run outlook, I am slowly
negative correlation to equities the underlying beta turning Austrian. The more I look at the current world
provides you. If you wanted capital preservation you situation, the more concerned I am about the growing
would put your money in an absolute return fund, leave it instability of the financial system and the reliance on
in the bank or even under your mattress. What that money-printing to drive even modest growth. The death
means is that we are singularly focused on generating of the fiat-money system is something I once thought
outperformance against our mandated benchmarks, and laughable but, in my humble opinion, as we continue to
hopefully the performance numbers we are generating stagger through this crisis it is gaining more
will help to offset some of the losses on the other side of credence. No doubt you don't want to hear that. You
the ledger. want me to be upbeat and tell you equities are going to
the moon and bonds have to sell-off, but unfortunately I
. can’t help you there.
www.btim.com.au

2. I was on the road visiting all the main centres with Crispin curve” and urging us to sell bonds or enter into curve
over the last couple of weeks on the BTIM Adviser Forum, flatteners (in this market – lazy shorts). This has been the
which was themed ‘Equities & Bonds - Dangerous same story for the past year, and despite every protest
Liaisons’ (view our presentations). The key take-away for we heard about Australian bonds being expensive, they
me was how much everyone hated my asset class. Most keep on getting more expensive, just as we have been
of the comments I received were something along the predicting. Part of this attitude was a lazy home bias in
lines of “bond yields are so low that they have to rise and terms of economic forecasting, another part was a
you are stupid not to see it” – I am paraphrasing here but favourable historical economic view on Australia given
not by much. For me the key point is that it's very easy to that it had avoided a technical recession during the worst
say something is expensive, but to expect it to cheapen of the crisis and, finally and probably most importantly, a
without offering any reason apart from its ‘obvious strong belief in the continued growth of China and the
expensiveness’ isn’t really an argument that I will use mining capex story.
when deciding my investment positioning. I was always
taught that an asset is never too expensive to buy nor too This fundamental view can be partially excused because
cheap to sell, i.e. something has to happen to change the our own central bank pushed that line for a long period of
trajectory of the price. And that ‘something’ is nearly time, even after the European events and a grab for safe-
always the medium-term supply-demand dynamic. Over haven assets affected the pricing of our interest rate
the short term extraneous factors certainly affect pricing curve, to the point where it became very clear that things
but the medium- to long-term driver of prices is always were worse than they thought. Two key things have now
supply and demand. It is very clear to us that in bonds changed in this fundamental view. The global stock of
currently there is a massive supply-demand imbalance safe haven assets has reduced markedly because of the
and that the pain trade is to much lower yields in the mass downgrading of sovereigns all around the world,
medium term. Obviously in the long term (ten years out) primarily in Europe. The second was the initial crowding
we agree that bonds offer little value, but in an out of the non-mining domestic economy due to a high
environment like the current one, high-quality AAA Australian Dollar and slowing credit growth and then the
government bonds remain the safest of safe havens, gradual slowing of China and its effect on commodity
which goes a long way in explaining why they are in such prices. We have remained long Australian bonds
high demand. throughout this entire period because of the expectation
that imbalances in Europe would have an effect on
To be clear I am not trying to be bullish bonds because I Australia through the financial system and markets, and
am contrarian by nature or trying to be different or even to that China would unsuccessfully make the transition to a
try to make this Newsletter a more interesting read. I am more developed economy growth rate.
bullish because it is what our process is telling
me. Regular readers will know that the nirvana for us in These are hardly viewpoints that point to the destruction
terms of positioning is when our Core-Scorecard models of the world financial system even though we get branded
line up with both our qualitative views and the technical with having this attitude. Being long bonds at this point in
input. This is exactly the position we are in now but we time does not mean the world will end. As long as we
also have the added kicker of market positioning which is think the markets aren’t priced for the potential
skewed against us thereby making the technical backdrop ramifications of what we envisage happening, then we will
even more positive. In terms of our investment process it remain in this position. We haven’t expressed our
is rare for all four factors to line up so consistently and viewpoint on Europe or China in any depth in a few
when they do we have to take note and run with the months, opting instead to provide some thought on issues
positions: for if not then, when? that aren’t as well covered. May saw the threat of a near-
term Greek exit and Chinese slowdown come to the
The key thing for you as clients though is the forefront and the story of these two economies is playing
diversification we offer. If we are wrong and bonds sell out in front of us, but there is further to go with simple
off it is likely that equities are strong and therefore that economics being the undoing of both.
your total portfolio will be performing well. If we are right
and equities come under stress in the coming few months Europe has again found itself at a crossroads. The Greek
then your bond allocation needs to perform to help offset election early this month was under-priced in terms of the
those losses. That doesn’t mean for one minute that we risk of triggering an early negotiation (I was going to say
will be blindly long in a rising yield environment as our re-negotiation, but there was no negotiation in the first
technical filters will take us out of our trades in short instance to speak of). New Democracy and PASOK (the
order. Ultimately you pay your money and you take your pro-bailout, pro-Eurozone parties) couldn’t muster a
choice, for us the risk-reward screams in favour of long sufficient majority after the unexpected performance of
bond positions right now. their main competitor, SYRIZA (anti-bailout, pro-
Eurozone). The anti-bailout, anti-Eurozone parties weren’t
So the pain trade is still for lower yields; It has been since significant enough to really challenge the more centre
February, probably even since August last year. May was aligned parties. After several failed attempts to form a
a month punctuated by a surprising Greek election result coalition from either side, eventually it was decided a
and poor Chinese economic data which resulted in a second election would be held on June 17. Polls up until
massive 85bp rally in Australian 3-year bond yields. To the end of the month are split between the two outcomes
put that number into perspective the average monthly and varying interpretations are just making the market
move of the 3-year bond since the GFC began is less more volatile while not delivering any clarity. Again, this
than 30bp. The move has been impressive, and our days event risk is another reason why you should be holding
don’t pass without another sell-side analyst expressing bonds.
how the RBA “would never cut rates as implied by the

3. The election has been declared a vote on Eurozone only is Europe as a whole giving MORE money to Greece
membership but we are not really sure this is the case. in addition to the bailout amounts, but it is actually giving
We are convinced that Greece will have to forfeit money directly to those Greek people who are smart
Eurozone membership at some point in the future, with enough to move their deposits. Why? If we assume
this election merely being a vote on whether that happens Greece is to leave the Eurozone and the Drachma is
now or later. For the record we think there is a 90% worth a fraction of the Euro (let’s say 50%, even though it
chance of a Greek exit in the next six months. Due to the will likely be much less than this) then the smart punters
indecision of the Greek people and the Troika’s lack of are getting 1 real Euro for every Greek Euro, instead of
patience with this, all cash disbursements under the only 0.5. When the Drachma comes back these people
bailout agreement have been suspended with the will keep their existing wealth in Euros. But for every
exception of cash for interest payments paid into the winner, there is a loser – and the loser in this case is the
agreed escrow account. Since all Greek debt is Eurosystem which gets to enjoy having all of its deposits
essentially official debt post the PSI, the Troika are really turned into the Drachma, losing half of their value. The
just paying themselves. What isn’t being paid though is smart Greek depositor is having money given to them for
the primary deficit, i.e. the Government’s budget deficit the pleasure of the EU having their fixed currency live on.
excluding interest payments. This was forecasted to be a The ultimate FX trade.
surplus for 2012 by Papademos and Merkel only eight
months ago but the theme in Europe (most notably in There is a lot of talk that deposit guarantees may be
Spain) that austerity plans rarely hit their intended targets introduced to try and stem the flow of deposits from
continues here. peripheral countries. Ignore this. Aside from the obvious
question of who is actually going to pay for these
The deficit has been reduced so far in the first quarter guarantees, they do not address the problem at hand
against 2011 but will likely finish the year somewhere which is not about the solvency of the banks in the
between 1% and 2% of GDP, if Greece stays within the periphery (although this is clearly a problem) but that
Eurozone. The problem now is that tax revenues have people are worried that their deposits are going to change
fallen off a cliff while in the limbo of a caretaker from a Euro into a Drachma or a Peseta or an Escudo.
government and encouraged by the possibility of paying No deposit guarantee will account for this, ensuring the
tax liabilities in a few months in a currency that’s worth continual flow of Euros out of the periphery. There are
only a fraction of the Euro held now. This means the rumours of structured deposit guarantees that will even
funding requirement skyrockets while uncertainty prevails, insure against a change in currency, but the chances of
and this has led the Greek Government to cancel the the Eurozone paying out insurance on deposits after a
equivalent of the Pharmaceutical Benefits Scheme country has left the monetary union are almost non-
(among other things) until bailout payments resume. Not existent, and depositors are realising this.
being able to afford your necessary medication is a quick
way to send your vote towards the anti-bailout parties,
even if the economic considerations aren’t fully Chart 2: Target2 balances
understood by the electorate.
In addition to funds provided under the terms of the
bailout, Europe is offering another convenience to the
Greek people in the form of a free put option of the value
of their savings in return for the ability to boot the can
down the road another time. Since Greece is still in the
Eurozone, all banking assets and liabilities are still
denominated in the Euro. As the probability of exit and
the return of the Drachma increases, more and more
people will likely get worried and move their savings
cross-border to a German bank, or perhaps to the nearest
mattress. In any other sovereign failure (Argentina in
2000 being a prime example) once this started Source: Barclays
happening, the banks would fail and the breaking of a
fixed currency peg (in this case the Euro) would have to It also seems that the number of smart people is
be brought forward and realised. increasing. The election has spurred deposit redemptions
not seen since the crisis in Greece started. Forget
As Bank of England Governor, Mervyn King, said election polls, or politicians rambling on. Unless Europe
recently: “it may not be rational to start a bank run, but it wants to be funding not only the government but the
is rational to participate in one.” The banking system is entire banking system of Greece indefinitely, something
the link between the likelihood of a country will have to give. European leaders will only want to keep
defaulting/breaking a peg increasing, and it actually kicking the can until an appropriate firewall has been set
happening. The TARGET2 (as it’s known) settlement up between themselves and Greece, but the problem
system in the EU allows deposits to cross borders and here is that, as with the austerity targets, the longer the
any deposits that leave, for example, a Greek bank and reality is forestalled other problems – like Spain and Italy
make their way to a German bank are replaced with a – make the firewall job even more difficult. The Eurobond
deposit indirectly from the German central bank. This is (a bond issued jointly by all EU members to fund all
great for banking stability because it means a bank countries within the EU) would be the ultimate time buyer
cannot experience a bank run because deposit amounts if the periphery was able to restructure to become
are guaranteed. Wonderful! However all this means is not competitive again. Sadly the adjustments necessary are

4. immense, and the core is unwilling to attract more liability simple economic principles and bet against both the UK
in such a transparent way that it is obvious to the staying inside the ERM and the politicians who tried to
electorate. This would help in the adjustment however – if keep the status quo. The same will likely happen here.
the interest rate on this new Eurobond was the current
average of all the individual country yields, Italy would Chart 3: Current Account imbalance in Europe
save 2.4% of GDP per year and Spain 1.7%. A bigger
winner would be Portugal, which would save 8.7% of
GDP on new debt issued. Obviously the core would pay
more, but it would go a long way to fix the imbalances as
well as buy time.
For the Spanish the threat of the return of the Peseta is in
addition to a banking system that, outside the big two
banks, is insolvent. The recent revelation of the
recapitalisation requirement for Bankia (itself an
amalgamation of 2 smaller failed banks) at €19 billion
highlights the difficulty of having exposure to a still falling
housing market that is far from a base. The Spanish
government attempted to get the ECB to indirectly take Source: IMF
the risk on this recapitalisation, as well as through some
clever transactions to recapitalise the bank. This was China was the other key theme for the month, and the
denied by the ECB, and the resistance by Germany and extraordinarily weak economic data super-charged
Finland late in the month to the previous plan of using the returns for Australian bonds. China is not too dissimilar
ESM to help Eurozone banks, highlights the ongoing lack from Europe in that persistent imbalances during the
of interest in the core of taking the needed steps to share decade leading up to the GFC has culminated in a
the debts of the periphery. With avenues for domestic situation where reversion to the balanced situation is
bank recapitalisation closing, we expect a Spanish bailout impossible without collapsing the economy. China ran
will be a certainty in the near future. current account surpluses for all of this period by having
two things – a low cost base for manufacturing, and a
We have written about the non-competitiveness of the
policy to hold down the value of the Yuan to make sure
periphery versus the core on a number of occasions. This
that its competitiveness against Europe and the US
position came about due to Germany joining with an
overvalued exchange rate which forced them to become wasn’t eroded by a rising currency. Holding a currency
extremely competitive during the pre-crisis years and this peg means accumulating foreign currency reserves
entrenched current account surpluses for Germany and through printing the domestic currency. This depresses
deficits for the mostly non-competitive periphery. Since domestic interest rates, causing all sorts of trouble when it
rates were accommodative and as they were catering for comes to investment. As a result the Chinese GDP is
the low inflation environment in Germany rather than the nearly half investment. When economists talk of
strongly growing periphery, debt was cheap and plentiful. “investment” they refer to the money spent on building
A current account deficit isn’t a problem unless it can’t be factories, equipment, infrastructure and housing and the
funded, so the great debt accumulation continued. requirement for these things has been strong due to the
Turning around a competitiveness problem in one year urbanisation of the Chinese workforce and strong export
that has built up over the last ten, whilst also having a demand. A bubble always needs a strong underlying truth
whole lot of debt to repay, isn’t an easy task. It’s almost for it to perpetuate, and the urbanisation theme is a
an impossible one for Greece, and the problem isn’t too strong one. There are many stories indicating the
different in Spain. imbalances caused by the currency policy have carried
on well past the effect of urbanisation, and the housing
Spain was another country that had run current account market is now approaching that tipping point. The housing
deficits for the years leading up to the crisis. In fact the industry in China is a primary driver of Australian
Spanish economy added 56% of GDP in debt in the years
commodity demand and has large ramifications for us. It
of 2000-2008 from current account balance data supplied
was also 13% of total GDP in 2011 (being approximately
by the IMF. Most of this was through the banks, with this
debt funding a huge jump in house prices and a a quarter of investment).
construction boom. The unwinding of this excess is
incredibly painful. Spain however is large enough to pose
a problem as the losses from an exit here would be too
big for the system to handle. Restructure of the domestic
economy is the only solution. This will mean falling wages
and thus living standards for the Spanish people, with no
domestic currency to help take some of the load. In this
situation, if things don’t go right, Spain may not be able to
leave, but the core may decide that they don’t want to
pay. Instead of the weak leaving and trying to get their
competitiveness up, the strong would leave to try and
bring their competitiveness down through an upward
currency valuation. George Soros realised how difficult it
was for the UK to maintain this peg because of these

5. Chart 4: China electricity output and GDP growth This picture highlights that the unravelling is beginning.
We have started to see Required Reserve Ratio (RRR)
cuts to help stimulate credit growth which has also
stagnated. Rumours of another fiscal stimulus package
pledging greater infrastructure spending is the last thing
that is needed as it will increase the imbalances further.
We are aware that it is likely to have a positive impact on
risk assets in the short run and we will manage our
exposures accordingly. The inflation picture, closely
correlated but lagged to credit growth, has slowed
sufficiently to allow directed fiscal stimulus. A change in
the leadership scheduled for late this year would increase
the probability of such stimulus, especially if the
universally weak data seen in May is the new trend.
This slowing in the housing market is occurring
Source: Bloomberg
simultaneously as China is moving towards running a
current account deficit. Rising import prices coupled with
slowing exports will result in capital eventually starting to
Chinese real estate investment is still growing at an
flow out of the country, when the modern experience has
extraordinary rate. The latest figures are still above 20%
been for current account surpluses and capital moving
growth from the year prior, however this has slowed from
into the country. While a movement to a more balanced
growth rates above 35% as the economy emerged from trade environment is good for competitiveness the world
the GFC with big fiscal stimulus. These growth rates are over, it would also mean China’s enviable $3.3 trillion
phenomenal, and apart from slowing slightly, show a foreign currency reserve would start being depleted and
strong housing sector. When comparing against home squeezing monetary conditions domestically. This may
sales however, the picture becomes slightly more grim. make China’s job to maintain the current growth rate even
Chinese home sales are now contracting at a yearly rate more difficult. More importantly though, it means that
of sub 10% after plateauing at a 20% growth rate for most China will need to sell its stock of US treasury bonds,
of 2010-2011. This has caused developers to rush to lifting US bond yields and de-railing the fragile recovery
complete projects and get their properties out the door there. Will this mean more quantitative easing? If growth
before others do, causing a massive spike in completions was affected we think yes but the bigger consideration for
in the first quarter of 2012. This rush has caused pressure the US is if interest costs start climbing, then austerity –
on house prices with 67 out of 70 cities now experiencing something they’ve been able to avoid – may come around
flat or falling house prices. The inventory of unsold real more quickly than the market is pricing in.
estate is increasing, with the pipeline now approaching 36
months in duration. S&P has outlined that the property The run up in credit growth in most developed nations in
developers it covers are becoming more financially the last 20 years before the crisis was a last dash,
desperate grab for easy growth and wealth when all the
stressed as high leverage ratios are starting to bite. As a
traditional growth drivers (population growth and
result, land sales have collapsed by more than 50% in
productivity) stopped occurring. The developed world has
April from the previous year. The provinces rely on land now found itself in a situation where the immense wealth
sales for most of their revenue, and this revenue is generated over centuries of successful capitalism is
needed as most of the debt that funded the huge Chinese getting more difficult to employ to make good returns, and
fiscal stimulus from 2009 remains at this level of as a result has led to this part of the world going ‘ex-
government. growth’. The US and Europe are definitely there already,
and the path of recent data suggests Australia may be
heading that way as well. While we got away unscathed
Chart 5: China real estate investment, home sales and the first time around, that was with a starting point of a
completion current account surplus. In this environment, deflation is
the most likely outcome as demand growth softens. Many
are worried about the printing of trillions in quantitative
easing packages the world over affecting inflation in the
near future. This is a real worry to be sure, but as long as
the demand for credit remains as low as it is then the
probability of this extra money making it into general
circulation is limited, and it will likely continue to remain
where it was initially created on the central bank balance
sheet, not hurting anyone. Keep holding bonds as they
will be your best investment, as growth and inflation
remain lower than the consensus expects.
Vimal Gor
Head of Income & Fixed Interest
Source: Bloomberg BT Investment Management

6. For more information
 Speak to your BTIM representative
 Visit www.btim.com.au
 Call 1800 813 886
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