LONDON Financial markets are underestimating the risk of mounting support for anti-euro parties within the single currency bloc and betting against French government bonds may be one way to hedge against it, Pioneer Investments said.
Pioneer's Chief Investment Officer Giordano Lombardo told the Reuters Global Investment Outlook Summit on Monday that 2014 still looked pretty benign for equity markets, with single-digit gains likely in the big developed markets as economic growth gained traction.
However, the powerful updraft from central banks' easy money policies was fading, so the scale of this year's gains of 20 percent plus on major western bourses was unlikely to be repeated.
What's more, political risks within the euro zone could well surface over the coming year and question the cohesion of the 17-nation area, Lombardo said. Rising support for parties opposed to the strictures of the single currency could pose a threat to monetary union not adequately discounted by investors.
"For the European story, I think political risk is not priced in," said Lombardo at Pioneer, which is owned by Italy's Unicredit (CRDI.MI) and has more than $230 billion of assets under management worldwide. "While it's not likely, it is possible that a major anti-euro party gets a major victory in a European country. This is not priced in."
Lombardo said popular resistance to the euro in countries such as France, Italy and the Netherlands - as well as within the hardest-hit bailout countries - could well find voice in right-wing or populist parties and next May's European Parliamentary elections could provide a lightening rod.
While there may well be some further narrowing of borrowing premia on peripheral euro government bonds in the offing next year, shorting low-yielding French government debt may be the best way to protect against a political shock, he said.
Euro break-up remains a remote possibility, he added, and a positive view is that Germany is the country which appears to have the least amount of public opposition to the euro.
But investors seeking to protect themselves from rising probabilities of euro discord may either demand higher risk premia or take a position against the core group of countries.
"France is a bit worrying," said Lombardo. "Clearly France is not enjoying strong growth, which is an understatement, it has had very few reforms, less than Spain and Italy and, on the other side, the bond market has been pretty benign."
"If one wants to take a hedging position towards Europe a safe way to do it is through the OAT."
Lombardo said that while Pioneer was more equivocal about "risk assets" next year than it had been in 2013, it remained underweight core government bond markets such as U.S. Treasuries and was "very short duration in our fixed-income portfolios."
The U.S. Federal Reserve will likely taper its $85 billion per month bond purchases during the first quarter of the year, he said, and "our central case is 10-year Treasury yields could be in the region of 3.5 percent" in 12 months.
But Lombardo reckons Fed policy and the market reaction could become a bit of a cat-and-mouse game, with U.S. monetary policy running through "switch on and switch off" modes.
As a result, Pioneer favored European stocks over U.S. equities, he said, with another easing by the European Central Bank possible in the form of further liquidity injections to the region's banks, or another Long-Term Refinancing Operation.
Chinese equities could also outperform, with last week's domestic reform agenda clearly welcomed by financial markets.
One positive economic surprise next year could come from the corporate sector, Lombardo added. Companies continue to sit on high levels of cash and natural capital expenditure needs - such as in computers and related technology - could well release some "animal spirits" over the coming year.
Follow Reuters Summits on Twitter@Reuters_Summits
(For other news from Reuters Global Investment Outlook Summit, click here)
(Additional reporting by Julia Fioretti; Editing by Susan Fenton)