We remain positive on bonds globally, feeling they are supported both by economic fundamentals and, ...
We remain positive on bonds globally, feeling they are supported both by economic fundamentals and, in the UK at least, by some strong technical factors. Globally, it is clear that growth will be lower this year than last, although the extent to which the US will slow is unclear. The 100bp of interest rate cuts we have seen since January certainly suggests the slowdown is severe, although the consensus is for a sharp rebound in activity in the second half of the year.
This scenario would be positive for US bonds, both government and corporate. A swift recovery should not endanger company balance sheets. Tax revenues should remain strong, protecting the surplus and allowing productivity gains to resume and exerting downward pressure on inflation.
The risk is that the US slowdown is more severe and more prolonged. In this case, long-dated bonds may fare badly as the surplus is eroded and the risk of stagflation increases.
European economies look better protected. They have little exposure to US trade, and fiscal easing is already in the pipeline. While this strength may see rates stay on hold for some time, the combination of further strength in the euro (which should benefit from better interest rate and growth differentials) and stable or declining oil prices should give the ECB scope to cut rates later in the year. In this environment, we would expect yields on bonds, particularly longer-dated bonds, to fall.
Conditions in the gilts market also favour lower yields and, while they may lag US Treasuries in the short term, gilts may well outperform on a longer-term view. In either scenario, yields on US bonds could eventually come under pressure a sharp recovery will favour equities, while a prolonged recession will threaten the budget surplus.
By contrast, in the UK the economic fundamentals are a policymaker's dream dull. Growth will slow, but only back to trend, giving the MPC scope to cut rates without endangering the inflation target. The prospect of lower rates, combined with the continuing lack of Government supply, will support gilts. However, gilts do look fully valued at current levels and much has been made of the fact that some special support factors will start to erode this year, principally MFR demand.
Changes in the MFR will undoubtedly push money out of long gilts and into credit across the maturity spectrum. However, the MFR in its current form remains in place and we feel that any change is unlikely this side of a General Election. Nonetheless, consultants are starting to include a greater component of credit in their benchmarks and, for this reason, we remain positive on UK credit although given the deterioration in global credit conditions, we would favour higher-quality bonds.
Eddie Middleton is investment manager at Britannic Asset Management
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