Fund manager's comment/Christine Farquhar
World bond markets have made heavy weather of 2001, but is there worse to come?
Recent experience has taught us that we are in a low inflation world, with many secular forces putting downward pressure on prices and margins. Pricing power, particularly for material goods, remains strictly limited.
New technologies have in-creased productivity and cost transparency. Monetary authorities are expected to target (and achieve) inflation rates in low single figures. In response, nominal bond yields have fluctuated, but have done so around a steadily decreasing secular trend.
The risk to bond investors will always lie with inflation. The risk today is that recent surprises in the economic data extend into even higher territory. If inflation rates continue to increase, and surprise on the upside, then the outlook for bond yields would obviously be less positive.
Rising energy costs, healthcare in the US, service sectors in the US and Europe, all represent increased risks to the general level of inflation. Over the last five or 10 years, admittedly, similar risks have never really materialised.
What is different in 2001 is that the monetary authorities are fighting a different battle. The Federal Reserve is clearly more concerned with avoiding recession than lowering inflation. The ECB is inclined to believe that European monetary growth has been significantly overstated, and that it is therefore safe to follow the Fed in reducing interest rates. In the UK, the MPC is relaxed about average earnings and consumer spending growth, to the point where Base Rate looks set to decline further to 5%.
The word stagflation always appears over-dramatic, more appropriate to the conditions of the 1970s than the new millennium. It is difficult to relate to today's economic circumstances. And yet, relative to the rate of economic growth we have experienced in recent years, it is significant. In particular, the impact on government finances could deliver a very unpleasant surprise.
Accidents happen when several risk factors combine to produce an unexpected event. In the case of bond markets, it is easy to forget the geared effect that an economic growth cycle has on government finances. In the UK, for example, the Treasury's economic model has invariably under-predicted the impact of slowing growth. Accustomed to an embarrassment of riches, the authorities may shortly be faced with a surprising shortfall in revenues, just as the government's higher spending plans come in to play.
History tells us that bond markets can absorb these shortfalls in revenue, with very little impact on yields, but only if the inflationary background re-mains truly benign.
Slowing growth, combined with increased inflation, would give a very different result.
l Economic growth has moderated.
l Bond yields have risen.
l Bond markets absorb revenue shortfalls.
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