Stronger economic growth will ensure corporate bonds and equities remain firmly on investors' radars this year, writes UBS Wealth Management's Bill O'Neill..
Recent years have been kind to corporate credit and equities. Now, with loose central bank monetary policy spilling over into 2014, companies will benefit from low debt-servicing costs, as well as the expected speed-up in the global recovery.
The resulting increase in consumer and investor confidence should further reduce the risk premium demanded for equities. And if the economy has improved enough for central banks to start hiking rates, it has probably improved enough for the yield spreads on corporate bonds to tighten and boost the bonds’ value.
What we have, as we move further into 2014, is an environment that gives credit to equities and corporate bonds more than liquidity and government-backed bonds.
Why equities and credit warrant attention
Why we favour equities
We have previously discussed how equities should play an important part in the long-term portfolio, even though returns may be some way off the 15% per annum high we have seen in recent years.
Our multi-year return outlook still speaks in favour of owning broadly diversified equities, especially compared to low yielding, high quality bonds and liquidity. Likely returns of 7% to 8% annually over the next five to seven years are not to be sniffed at.
Recent turmoil in emerging markets has spooked investors. As ever, our view is to keep faith over the long term. It is true that the growth advantage emerging markets have enjoyed relative to the developed world will continue to decline in the coming decade. But we are inclined to see the recent sell-off in emerging market equities as more of an opportunity than a threat.
The direct impact on broad emerging market growth should be relatively limited, given that, at this stage, issues are contained within small and peripheral economies.
Due to its favourable risk-return trade-off and its deleveraging lead, the US deserves a chunky proportion of investors’ attention. We expect the US market to return about 7% per year. In the eurozone, the gradual economic recovery should translate into rising earnings and enable eurozone equities to outperform the UK and Switzerland.
Credit the better option
Unprecedented central bank policies drove bond yields in many developed countries to record lows in recent years. In the past, holding liquidity and government bonds was a safe strategy. Now they have become ‘risky’ by exposing investors to losses, as portfolio yields could fail to keep up with inflation.
In our view, developed market corporate and emerging market bonds will outperform government and high grade bonds in the years ahead and will help offset the effects of this trend by offering a better return outlook.
An improving economic outlook should result in a tightening of the yield spreads on corporate bonds and an increase in the value of those bonds. To account for this heightened relative attractiveness of corporate and high grade bonds, we recommend increased long-term exposure to investment grade corporate bonds.
To further avoid the risks of rising interest rates, we are also focusing on bonds with a relatively short maturity of one to five years. High yield bonds offer a distinctly attractive risk-return profile.
The vast growth of the emerging market bond market in recent decades has caused its risk-return profile to evolve, so it should be reassessed in a global portfolio context.
While emerging market bonds were perceived as a highly risky asset class a decade ago, today they are similar to developed market credit investments. In addition, emerging market companies today do not limit their activities to their home and neighbouring countries but have become global players.
Given the convergence of credit ratings, the global business focus of many emerging market companies and the ease of investing in emerging market bonds, the categorisation into emerging markets and developed markets becomes less distinctive.
Emerging market sovereign and corporate bonds help to diversify portfolios into attractive sources of yields. As a result, we recommend a small strategic position in emerging market bonds for most portfolios.
Stronger economic growth and accommodative central banks will ensure that credit and equities remain on investors’ radars in the coming months and years. Give credit to both when positioning your portfolio in 2014 and beyond.
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