Hardly a day has gone by in 2011 without fresh headlines about the sovereign-debt woes of Greece and other developed countries. It’s still unclear which path governments will take to resolve their growing debt burdens, but one thing is clear: the path taken to fiscal rectitude will have great implications for fixed-income investors.
In our view, apart from default, there are three possible ways out of a government debt crisis: growth, inflation and austerity.
Faster economic growth would lead to greater tax revenues, reducing the debt burden. Inflation—via a weaker currency—would help reduce the debt burden in real terms. And austerity would directly slow the growth of debt through spending cuts or tax increases (or both).
Of course, any solution may involve a combination of these three strategies, but let’s take a look at the investment implications of each in turn.
First, let’s look at a growth-based strategy. Under such a scenario, high-income strategies would probably be the biggest winners in the fixed-income universe; these would include high-yielding corporate debt and possibly other high-yielding sectors such as emerging-market bonds. Core fixed-income strategies, which are more conservative by nature and focus on investment-grade bonds, would likely underperform.
What about an inflation-based strategy? Not surprisingly, we’d expect investors with explicit inflation-protection instruments in their portfolios—such as US Treasury Inflation-Protected Securities (TIPS) or other inflation-linked bonds—to perform the best. High-income strategies would also likely fare well in such an environment, as the generous coupons of high-yield bonds would help portfolio returns to outpace inflation. All bets would be off in the case of runaway inflation, though: history suggests that runaway inflation would be harmful to the bonds of high-yield issuers.
As for an austerity-based strategy, we’d expect investment returns to be low across the board. Core fixed-income strategies would probably perform best, while high-income would suffer the most.
So how should an investor prepare for the coming era of government deleveraging? Since it’s highly unlikely that any one of the three scenarios above will be the single solution, no single fixed-income strategy is likely to provide an all-weather solution in the years ahead.
Furthermore, the policy mix varies between countries. Many members of the euro area are taking an austerity path, with tighter monetary policy exacerbating the downside risks to economic growth. Meanwhile, the US is attempting to revive growth via aggressive monetary easing, and has not yet started deleveraging on the fiscal side. The UK is taking a middle ground, tightening fiscal policy while keeping monetary policy highly accommodative. Only time will tell which policy approach is effective.
Given this uncertainty about policy outcomes, diversification is critical. A well-balanced combination of portfolio strategies and a global approach to investing will almost certainly be the best way to help investors weather the storm. In an age of heightened uncertainty, that’s something to take comfort in.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Douglas Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.