Don't worry about volatility, says Lehman bond strategist

Fixed-income strategist, Jack Malvey, says investors have been too conservative despite the latest 'risk flares'.
Jack Malvey, fixed-income strategist at Lehman Brothers, visited Hong Kong as part of a regional tour to promote the firm's investment outlook for 2007.

You timed your trip well. What were your observations of what happened in the equity markets at the end of February, and what do you call it?
We call it a risk flare. Specifically, it was a combination punch that hit the capital markets û it was not exclusively triggered by the volatility in the Chinese equity markets. What has happened over the course of the last couple of months is investors have begun to get a little bit anxious about eight months of continuous out-performance in equities and spread compression in credit assets, and so they were wondering when the market might take a break.

At the same time, there was geopolitical risk and some disconcerting inflation news in the US. In the credit markets there was also consideration of what was going on with negative event risk as the deal pace continued to move at a fairly incredible velocity and then of course there's sub-prime mortgages and what's happening in that market. Whatever the asset class, investors are wondering what a sub-prime correction means for them?

Then finally at the end of February there's a Chinese equity correction with the rest of the region going down, and that created a burst of volatility and a correction across equity markets û you can only take so many doses of slightly negative changes.

It looks like volatility is returning to the markets?
Volatility was very high during the 2000-02 period, then the economy recovered and it came down û it's a standard cyclical configuration. Before you get to the next cycle, where volatility is very high again and the world economy gets crushed, what you get is like a little tremor, so in May/June last year we had a little tremor and now we've had a bigger tremor. As you get closer to the next cycle you see more tremors, so on average volatility is going to be a bit higher this year than the last two or three years, but it's not going to be sky high. Over the next two or three years it will probably go up a little bit each year for the very simple reason that it's a manifestation of uncertainty; people are not sure what the future holds and therefore markets bounce around more.

You mentioned spread compression in the credit markets and obviously there's been a huge bid for Asian credit this year. Do you think the levels of liquidity we've seen are sustainable?
If you look at global financial asset returns since the 1920s you will see the reason why there's such interest in anything that has higher yield: this decade we have only a 3.6% total return, which is the lowest return on financial assets per year in six decades, so there's a mad scramble by all types of investors to look for instruments that somehow provide the combination of higher yield and higher total return. So they're willing to do things maybe they were less willing to do five, 10 and certainly 20 years ago.

There's also been this tremendous globalisation across the world's debt capital markets during the last 25 years. We've been talking about this since the early 1980s, but it really has arrived. Here in Asia we have investors who are all over the US mortgage market, and investors over in the US and Europe and the Middle East telling us about the Asian credit stories. You wouldn't have found that five or 10 years ago, for sure. It's a very exciting time.

How long will returns continue to remain so low?
Well, lower returns this decade are certainly a function of equities in 2000-02. Even so, we conjecture that world financial asset total returns for public instruments may be hard placed to meet the 7% long-term average during the next 15-20 years.

We say that because we believe in the power of central banks to keep inflation and rates low, therefore bond returns as a contributor to total returns might remain in this low to mid-single digit space û say 2-5% û for the indefinite future. That is our assumption 2007-09; that we're not likely to see anything much above 5% for any regional market in any one year, and that's also likely to continue into the next decade. Broad demographic trends support that notion as well.

The other thing that keeps yields low are the imbalances that central banks continue to accumulate, not just the Asian central banks but also the petrodollar recyclers, so it kind of feels like this environment is here to stay û and I'm really aware of the absurdity of trying to pretend that I can see what 20 years out is really going to be like, but that's our conjecture.

What's your view on fixed-income investment opportunities in Asia?
Our overall view, not just for Asia, is that the G4 bond markets are pretty well examined; that the ability to outperform those markets is more difficult and therefore investors, global investors, are probably well served by looking around for valuation opportunities in some of the so-called peripheral markets and indeed there's a whole set of them here in Asia.

In terms of the relative attractiveness of the Asian capital markets, I think the credit story here may be the best in the world û we have higher quality elements within our main indices, a lot of companies still have some family interest, which reduces the negative event risk, the financial leverage often tends to be less than many firms in the US and Europe, and from a credit investor point of view you're probably always better off buying into a strong and growing economy û and, of course, Asia leads world growth on a composite basis.

Finally, how did your predictions for 2006 turn out?
It was a pretty good year really. We were right to think the world economy would continue to expand, we were right to say equities would do much better than bonds and we were right to suggest that credit would outperform again, though it turned out to be even better than we expected.

On currencies, we thought there would be more appreciation of the yen and we were a little surprised by the magnitude of the appreciation of the eurozone. We thought that volatility would pick up last year and it really didn't, it was very slow. We were pretty good on the Fed and major central bank movement, but then again they're doing a pretty good job of telling you exactly what they're going to do.

Somewhat atypically for sell-side guys, our major errors were because we were too conservative. We're not alone in that û this cycle has been under-estimated by so many people.
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