Investec sees euro crisis flare-up risk; short French bonds vs Bunds

LONDON Tue Nov 19, 2013 10:55am EST

LONDON (Reuters) - Stagnant growth and possible deflation could trigger fresh upheaval in Europe next year, says Investec, which has short positions on peripheral bonds and expects European stocks to lag other developed equities in 2014.

Philip Saunders, Investec's head of multi-asset investment business, told the Reuters Global Investment Outlook Summit on Tuesday that European equities would probably deliver positive returns next year but inflows of cash rotating from emerging and U.S. markets could soon dry up.

"Everybody's gotten carried away with the whole European revival ... but the view that the (euro) crisis is over is wrong," Saunders said at the summit, held at the Reuters office in London.

"We think the periphery trade is done ... risks are more pronounced than markets believe, you don't feel compensated for additional risks."

Saunders, who helps manage over $100 billion in assets, reckons the European Central Bank will just about manage to evade outright deflation, though it will remain unable to embark on bond buying, a course the OECD group of industrialized nations advised on Tuesday.

Peripheral bond yield compression has run its course, he says, while worries about the slow pace of reform in France keep him short on French as well as Italian bonds versus German Bunds.

France appears to be "heading south", he said, noting its weak leadership and diverging unit labor costs with Germany.

Europe's weaknesses will also become apparent to equity markets, he said. Stock markets across the bloc have rallied this year, with German stocks up 20 percent .GDAXI to record highs. Spanish and Italian bourses have gained 16-18 percent.

"The big trade that has happened over the last six months or so has been selling EM equities and buying European equities. I think that trade's done," Saunders said. "The earnings dynamics collectively look poor, we doubt that's going to change much."

While European company earnings are likely to stay in positive territory, Saunders predicted that the United States .SP and Japan .N225 would continue this year's sharp rallies, outgunning emerging markets .MSCIEF yet again.

"We expect Japanese equities to deliver the best returns of all developed markets," he said. "We've been in an equity bull market in the developed world since 2009 ... and it certainly looks like this cycle is going to be a long, drawn out one."

TREASURIES, TAPERING, RISKS

Like most investors, Investec expects the Federal Reserve to start winding down its bond buying in the first half of 2014 as the U.S. recovery gathers pace. Ten-year yields are up almost 100 bps this year on this expectation to around 2.70 percent.

"The next leg of tapering could take us 100 bps higher and we'd be buyers at those levels," he said.

However, incoming Fed chief Janet Yellen has indicated that bond buying is likely to continue in the short term. Saunders said the risk was that disappointing growth or falling inflation could prolong quantitative easing, with negative implications for various asset classes.

"(Taper delay) creates problems in the sense that it has the potential to exaggerate some of the distortions that have occurred ... You get more credit-fuelled growth in countries that could do without it, you get further mispricing of real estate assets, another run-up in emerging debt," he warned.

Saunders is cautious about corporate credit, an asset class that has benefited hugely from the ample liquidity supplied by central banks but could take a hit from regulations that have cut the number of market players and sapped liquidity.

"Investors are still heavy owners of credit exposure ... That means there is a sort of overhang and deterioration of credit quality ... That's a place which could contain some unpleasant surprises next year," he added.

Cyclical shares that will benefit from the growth recovery are a better place to be than corporate credit, he said. U.S. industrial companies that are boosting capital expenditure to fuel future growth are likely to outperform firms focusing on dividend payouts and share buybacks, he said, describing the latter as "value traps".

"Companies that do well are going to be the companies that deploy capital more sensibly. Quality cyclical companies ... are going to outperform the high-dividend stocks."

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(Additional reporting by Julia Fioretti; Editing by Susan Fenton)