Although recent data is coloured by events in the Gulf, the outlook for growth in the UK has not imp...
Although recent data is coloured by events in the Gulf, the outlook for growth in the UK has not improved.
Sterling may have weakened against the euro but industrial production remains subdued and consumption is under pressure.
Consumer confidence, rising house prices and full employment have all helped underpin consumer activity in the past few years but these factors are beginning to recede.
The subdued growth recorded in the first quarter hints at a sharp rise in spare capacity and there is nothing to suggest this will disappear any time soon.
While inflation remains above its core target rate of 2.5%, if there is continuing underlying weakness in UK data, the Monetary Policy Committee may be encouraged to act to provide a boost to flagging demand within the economy.
A rate cut will provide further impetus to the gilt market with yields heading even lower.
However, the ongoing strength of the market may be shortlived. A substantial increase in gilt issuance to finance the Government's public spending plans will not help and while another rate cut will probably occur in the short term, the 12-18 month view of interest rates is that they will have bottomed.
With this in mind, our house view is that yields will slowly begin to rise over the next 12 months, in particular at the long end of the market.
The outlook for investment-grade bonds is less clear cut. The asset class has performed well since the start of the year. Highly-rated issues have continued to track the performance of the gilt market while lower down the credit curve and spreads have narrowed considerably from their levels at the start of the year.
In this part of the market, A and BBB issues have received support from investors in their search for yield and have been buoyed by the undertaking of companies to deleverage their balance sheets.
In addition, there has been an increase in risk appetite among investors, particularly after the war in Iraq. However, it is probably time to take profits in some of these bonds.
While we are not expecting a sharp widening of spreads, the levels they are currently at do not fully reflect fundamentals but rather a degree of investor sentiment and technicals.
The telecom arena is a good example of a sector in which we have seen excellent performance and in which we are selectively taking profits.
We remain positive on the fundamentals but prefer some of the higher beta names.
Any short-term spread widening on A and BBB paper due to profit-taking should be limited.
The second half of the year is likely to be characterised by a gradual rise in gilt yields, with investors moving further down the credit curve to lock in higher yields to compensate for expected capital losses from the market move.
Another way to mitigate capital losses from the market move will be to increase exposure to Floating Rate Notes (FRNs). The attraction of an FRN is that its coupon adjusts quarterly to reflect current interest rates, leaving its price relatively stable.
For a bond, the coupon is fixed, so the price needs to move lower to reflect higher yields.
Further cut in interest rates expected.
Firms deleveraging to improve balance sheets.
Investment grade spreads have tightened.
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