By David Parsons, fund manager, Lombard Odier Darier Hentsch Asset Management Once again the UK ...
By David Parsons, fund manager, Lombard Odier Darier Hentsch Asset Management
Once again the UK fixed income investor starts the year having to form a view on extracting excess return from bond markets based on macroeconomic, market and geopolitical analysis.
We cannot look at the UK in isolation so let us start with the US, the engine of global growth. According to the Fed, the US economy is working its way through its current soft patch.
However, the negative effects of over investment and excessive balance sheet leverage in conjunction with the lagged effects of rising unemployment and declining equity markets are making any pick-up in business and consumer confidence somewhat slow. If we add geopolitical uncertainty to this macroeconomic backdrop it seems we may have some justification for risk aversion.
Well, not in our view. With the Fed more worried about the downside risks to growth than the upside risks to inflation we have a favourable environment for inflation-linked notes. In particular, US inflation-linked notes on a currency hedged basis provide the sterling-based investor with generous carry and protection should yields rise.
In the sterling market, last year's trade was convergence between long term UK and eurozone bond yields both in the nominal and inflation linked markets. The driver of this trend was held to be the lack of EMU risk premium priced into the sterling yield curve, which highlighted the richness of the market relative to equivalent eurozone bonds.
In reality widening growth, inflation and short-rate differentials also played their part. This underperformance of sterling bonds in general and gilts in particular appears set to continue.
By way of background, from the mid-1990s the demand curve for gilts (and sterling bonds in general) shifted to the right, reflecting a well-documented shift in UK institutional asset allocation in favour of fixed income. This institutional bias lowered sterling bond yields below levels justified by macroeconomic fundamentals.
The obvious downside risks to the UK Treasury's 2.5%-3.0% 2003 growth projections generate upside risks to the Treasury's funding requirement, with gilt supply already forecast at its highest level since 1993. This shift to the right in the gilt supply curve will offset this institutional bias and increase the focus on the miss pricing of the UK's term structure of interest rates.
These factors are likely to give rise to some further UK bond underperformance irrespective of the status of the EMU debate. Within the gilt market, index- linked bonds should outperform conventionals, reflecting growth orientated central bank monetary policy and generous prospective inflation indexation.
Elsewhere, the wide spread between long dated index linked gilt yields and French inflation-linked notes will be the target of the market this year. This reflects the relatively slow progress of real rate convergence between the UK and eurozone we have seen up to now.
Investors needing to hold sterling bonds should buy eurosterling. The rising UK government deficit will ensure that sterling swap spreads will tighten to the narrow levels that exist in the eurozone market.
Risk aversion will ensure strong demand.
Asset allocation remains supportive for bonds.
Low rates are positive for index linked gilts.
Rising deficit may hit demands for UK gilts.
Rsie in gilt supply offsets institutional bias.
Convergence makes indexed gilts vulnerable.
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