We’ve Entered the Storm Before the Calm

06/22/2011 8:30 am EST


Paul Tracy

Editor, The StreetAuthority Market Advisor

Things may look messy now...but by the end of summer, international income plays will be a very good place for investors, say Paul Tracy of High-Yield International.

Stock markets dislike uncertainty in any form. Right now there are multiple sources of risk hanging like a dark cloud over market sentiment.

The good news: much of the current malaise should clear up this summer.

Topping the list of concerns is the disagreement in the European Union over how to handle ongoing Greek fiscal woes. As the largest economy in Europe, Germany tends to take the lead in discussions about new bailouts for troubled countries.

Meanwhile, the European Central Bank and its president, Jean-Claude Trichet, came out against the original Schauble plan, saying that the bank would only support a voluntary restructuring of Greek debt.

The bank further warned that such a restructuring would constitute a default, and risk spreading contagion to other troubled borrowers in the region, such as Ireland, Portugal, and Spain..

[The German finance minister's original plan, which would have extended the maturities of Greek bonds, was dropped in favor of the compromise plan announced this weekend—Editor.]

Of course, the ECB is worried about its own balance sheet. The central bank stepped up last year, when the Greek crisis first erupted, as a lender of last resort.

It's now estimated that the ECB holds around 40 billion euros ($57.2 billion) of Greek debt. If that were to be restructured, the bank might need to raise additional capital from Eurozone governments.

Another source of uncertainty facing global markets is the completion of the Fed's second round of quantitative easing at the end of June.

Fed Chairman Ben Bernanke has been clear in saying the bank has no plans for a third round at this time; it's likely that economic data would need to deteriorate markedly before the Fed agreed to more bond purchases. Many investors continue to fret that the end of this program will spark a flight from riskier assets, including stocks.

But while the Fed will complete its $600 billion program to buy government bonds, the central bank has said it will continue to reinvest interest and principal payments from bonds that mature, and plans to keep monetary policy loose for a prolonged period.

Unlike the period immediately after the first round of quantitative easing, the Fed isn't planning to shrink the size of its balance sheet until there are signs the economy is on a stronger footing.

Another major conflict brewing in Washington is the debate over the US federal debt ceiling, the maximum amount the government is allowed to borrow. Congressional Republicans have insisted that President Obama and Senate Democrats agree to significant spending cuts before they'll vote to increase the size of the debt ceiling.

The most likely outcome remains some sort of compromise. The Treasury department has stated that the government will run out of money in August, so Congress will have to act quickly to reach an agreement or risk a US debt default. Jitters ahead of that deadline have shaken markets the world over.

Finally, the economic data in the US and Europe has been coming in consistently below expectations for more than two months now, prompting some to fear that the global economy might be at risk of slipping back into recession.

But growth continues in core economies like the US and Germany, and calls for a contraction appear premature.

There's a silver lining here for income investors: With the macroeconomic and geopolitical picture so uncertain, the safety offered by regular dividend payments becomes even more attractive.

High-yield energy holdings such as Atlantic Power (AT) and Bonterra Energy (Toronto: BTE) have managed to buck the trend in the broader market over the past month and a half, because their dividends are backed by solid long-term contracts, growing cash flows, and healthy dividend-coverage ratios.

And when stock markets wobble, investors tend to run for the safety and security of bonds. That's aided the performance of my closed-end bond fund holdings, including Templeton Global Income (GIM) and AllianceBernstein Global High Income Fund (AWF).

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