At a time of global slowdown, investors are turning to the relative safety of bonds, says Bob Attridge
As one would expect, the ill wind of a US-led global slowdown has created a positive environment for bond investors around the world. Between the start of the new millennium and the end of May 2001, benchmark 10-year US Treasury yields fell by more than 100 basis points (1%). Elsewhere, yields have typically fallen somewhat less, around 20 basis points in Europe and 40 in Japan.
A sterling investor would have generated a gross return of around 12% from investing in the components of the JP Morgan Global Bond Index but would actually have made more (14%) from a non-interest bearing US dollar current account.
Rising bond prices in Europe and Japan have largely been offset by currency weakness. Given the apparent severity of the global downturn, it is hardly surprising equity investors have fared rather worse. Over the same period, the MSCI World Index is down by about 10% in sterling terms.
Burned by plunging stock prices, investors' appetite for risk shrivelled from the high point of early 2000. This meant the security of high-quality, fixed interest exposure (as well as the traditional safe haven of the US dollar) looked particularly attractive. On top of this, inflation, the nemesis of bond investment, had been looking pretty tame, even while US growth was accelerating.
Thanks to strong productivity growth, global competitive pressures and the internet's impact on price transparency, economists expecting to see a classic Phillips curve relationship between low unemployment and an inflationary pick-up were consistently disappointed.
More support for government bond prices also came from the supply side. Outside Japan, robust economic growth boosted tax revenue at the same time as falling unemployment trimmed expenditure on benefits. The finances of the UK and German governments were improved still further by the absurd prices paid by the telecom sector to secure third generation mobile phone licences (3G).
If the forecasts of mounting surpluses were to be believed, governments would have no need to issue more debt ' quite the reverse, in fact. The prospect of a shortage suppressed yields, especially at the long end of the curve in countries such as the US and the UK, which were running government surpluses.
In many ways, the most surprising thing is that bond yields have not fallen further, although there are various reasons we can suggest for that. The budget surplus factor is already not what it was and the Bush administration took office determined to push through substantial tax cuts (the original proposition was actually based more on the desire to distribute some of the surplus than to stimulate a weakening economy).
Bond investors have also learned to be wary of getting carried away in times of economic slowdown because an upturn always follows as surely as night follows day.
As a result, they have erred on the side of caution, expecting the US economy to be roaring back by year-end and ignoring the implications of all the developed world economies turning down and the bursting of the tech bubble. The risks, in terms of the outlook for the global economy, all seem to be on the downside.
However, the most serious challenge to the equanimity of bond investors has come from an unexpected quarter. Having lain dormant while the global economy was steaming ahead, inflation has reared its ugly head just as a co-ordinated downturn has become apparent. The most important implication of this has been for eurobloc interest rates, where the European Central Bank (ECB) seemed only too happy to drag its heels in respect of monetary easing. As expected, rate cuts were postponed, confidence in the new central bank was damaged and the currency suffered accordingly.
So, should we be worried by this rise in inflation? The basic answer is no, although the extent of its rise in the eurozone suggests that structural reform there has not progressed as far as we might have hoped.
Our reasoning is that the two main sources of higher inflation, energy and food prices, are both supply-induced. Elsewhere, there is little sign of anything untoward developing and we believe the severity of the global downturn will progressively be reflected in price levels, although inflation will continue to live up to its reputation as a lagging indicator. The risk is that by concentrating on inflation when the major problem relates to growth, central bankers risk making the downturn even more serious.
Fortunately, Greenspan clearly seems to believe inflation is not a threat. Indeed, the major positive influence on the global economy at present is the willingness of the Federal Reserve to cut US borrowing costs aggressively. Since that first, unscheduled 50 basis point cut on 3 January, further reductions amounting to another 2% have been made and we expect more cuts until the Bush stimulus begins to be felt later in the year.
The speed with which the Fed has been prepared to react to the deteriorating situation contrasts starkly with the response of the ECB, who, for some time, appeared to believe the European economy would be unaffected.
We do not expect recent or future easing to transform the outlook overnight. Indeed, as inflation is seen to come back under control, we would expect bond yields to move lower again, having backed up a little in recent months.
We are currently overweight US bonds, anticipating that we can derive some benefit from a further mild reduction in yields. Furthermore, the falling surplus and likely slowdown in corporate loan demand suggests corporate bond spreads will benefit from the reduction in relative supply over the next year.
However, unless the US economy fails to bottom out, and the situation is even more serious than we think, yields are likely to pick up again as 2002 progresses.
Europe is more difficult to call because it is not yet clear sufficient confidence has been created in the currency for its 'obvious' cheapness to assert itself. Our current weightings are therefore not far from neutral.
With the dubious distinction of its currency having fallen significantly against the euro over the past six months and its bond yields having risen relative to benchmark Bunds, Sweden offers a more risky, but potentially more profitable, way of participating in any recovery in European bond markets and currencies.
Our major underweight position is in Japan. Yields are so low as to be almost invisible, a description that can in no way be applied to the fiscal deficit and the accumulated stock of government debt outstanding. The Bank of Japan has yet to demonstrate wholehearted enthusiasm for its new policy of printing money and the new Prime Minister may find it more difficult to introduce long-overdue reforms than the markets originally anticipated.
In any case, reforms aimed at allowing market forces to work their magic on Japan's ailing economy will almost inevitably first result in a recession. Bond yields close to 1% for 10-year Japanese Government Bonds already reflect that but the currency continues to look vulnerable. As for bond yields, and therefore prices, if Koizumi does succeed in reigniting the long dormant Japanese economy, they just do not bear thinking about.
Investors' appetite for risk shrivelled after tech bubble burst.
Rising bond prices in Europe and Japan offset by currency weakness.
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