Treasurys to maintain extreme volatility

The following is an excerpt from the January commentary of John P. Calamos, Sr., CEO and co-CIO, and Nick P. Calamos, president of investments and co-CIO, of Calamos Advisors. To read the full commentary, click here.

Do we stay biased toward the reflation sectors and assets in 2012? We have been debating this over the past few months. As the evidence has presented itself over the past few weeks, we believe we stay the course and only reduce our risk-asset and reflation-asset exposure into strength. Let’s hope the global central banks act in a manner we expect and as they have in the past and reflation assets should rebound.

We expect a continuation of a two-tiered U.S. economy, with more deleveraging and deflating at the state government, local government and household levels. We anticipate muted growth or continued contraction in the financials, housing and construction industries on the whole. However, we are focused particularly closely on the housing market, as it appears to be stabilizing and perhaps even showing signs of a little life. Meanwhile, the other side of the U.S. economy is growing with expansion in the information technology, energy, health care and industrial sectors and some retail areas.

The U.S. is still in a wealth destruction stage, via inflation in fees and taxes. As deflation in risk assets persists and volatility rises, investors are more inclined to sell into the downside phase. Finally, repressed interest rates steal from those on fixed incomes and U.S. pension plans while higher regulations and tax burdens discourage businesses from taking risks or making decisions. These problems are mirrored in many other developed markets. We won’t be in a secular bull market until these things change and debt deleveraging runs much deeper.

Globally, we expect that financial markets will remain very volatile and hypersensitive to government policy initiatives and the unwinding of private and public sector debt. We expect investors will keep their time horizons short and further rein in durations on risk assets. The only long-duration assets that did well in 2011 were U.S. government bonds and gold—the ultimate safe havens (at least in theory).

In many investors’ eyes, gold is the real store of value and its appeal directly correlates to the demise of fiat money and the banking system. Government bonds appeal to the “risk-off” crowd that still believes U.S. government debt can provide a store of value and preserve wealth, at least in the near term. We have yet to find anyone who believes they will generate a real positive return on Treasury securities held long term (10 years or longer). Instead, many investors seem to be holding Treasurys as a ready-to-trade-asset, with the expectation of exiting at the first sign of credit or inflation problems. Because of this, we expect that Treasurys will continue to be extremely volatile.

High-grade and mid-grade corporate bonds may still offer the most dependable source of low-risk-but-still-positive real return. Investors must balance credit risk and duration risk as the global recession risk is likely once again higher than inflation risk. We believe that developed market government bonds offer an exceptionally poor risk-reward as the bubble in government debt expands, but timing the eventual correction is very difficult.

In our view, a broad-based expansion in price-to-earnings multiples in the developed world is unlikely in 2012, given political uncertainty and global banking and debt problems. Equities are subject to the risk that a global recession or slowdown puts pressure on profit margins and at the same time P/E multiples contract as uncertainty about the path to economic sustainability remains unclear.

Emerging markets may provide an area of opportunity, although they are still reliant on developed economies to fuel their growth. As we noted, risk and risk awareness are high and time horizons for investors are short. It is no different at the corporate level, as uncertainty about the global economy, taxes, regulations and lack of political will all shorten the duration of businesses’ outlooks. Therefore, large capital projects and long-term growth initiatives are few. Business people and investors alike are limiting the risks of long-term capital investments in this volatile and fragile global business climate.

Although we highly doubt the onset of a new secular bull market in 2012, the opportunity to build a stronger foundation of financial sanity, global leadership and fiscal recovery is in the realm of possibility. We also believe the equity markets will respond to a combination of monetary reflation and fiscal restraint as long as pro-growth fiscal policies are part of the offering. In our previous outlook, we demonstrated that the unwinding of massive debt has corresponded in the past with equity bull markets and bond market malaise. The only difference this time is that the developed world economies have promised the populace welfare in excess of the ability to provide it.