Fund manager's comment/Michael Gonnard
The realisation that interest rate cuts alone were not sufficient to prompt a sustained rally in global equity markets hit home in July.
With the Fed cutting interest rates by only 25bp at its 27 June meeting, it has been the dire state of corporate earnings which has dominated the market mood lately. Against this backdrop, bond markets have performed well as inflation fears recede and evidence of economic recovery remains patchy.
Interestingly, UK interest rate futures did not discount the 25bp cut on 2 August and are still pointing to the next move being up. We are less pessimistic than the market and expect rates to remain stable for some time. We are only forecasting a rise in base rates back to 5.5% by June 2002 against the consensus forecast of 6%. However, conflicting signals at home and across different parts of the world make the immediate outlook unclear.
This is exacerbated by timing differences between the economic cycles of Europe and the US, and between monetary easing and economic growth.
On a valuation basis, UK gilts continue to look cheap in relation to European markets. Although the inflation profile in the UK has moved in line with global trends, it remains the healthiest in Europe on a harmonised basis. It is therefore hard to see why yields on government bonds in the UK should be higher than those on bonds in other European countries.
As we move into the second half of the year, we still expect to see some modest improvement in the global economy, continued easing of liquidity and improved investor confidence towards equity markets.
Key to all of this remains the situation in the US. Since 3 January, the Fed has announced interest rate cuts totalling 2.75%, representing a significant decline in nominal and real interest rates.
Although the most recent cut was just 25bp, we do not believe that the easing cycle is necessarily over. In all likelihood, headline inflation, which has been surprisingly high this year, will decline as a result of lower oil prices and the continued strength of the dollar. That will provide Alan Greenspan with the scope to keep edging rates lower if necessary. However, we remain convinced that rate cuts do work and that the US and the UK will avoid the 'Japanese syndrome'. Experience from the past seven easing cycles in the US shows that the average equity market return over the 12 months following the first cut in each cycle has been 21%. If this would be bad news for government yields, it could be good news for the corporate bond market.
The recent downgrade in earnings expectations has been accompanied by a dramatic increase in the ratio of credit rating downgrade to upgrade. As a result, the spread between BB-rated and AAA-rated issues has remained historically high (current +230bp versus average of +140bp). These represent genuine investment opportunities.
• Gilts cheap against European markets.
• Stable outlook for UK interest rates.
• Improvement likely in global economy.
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