Fund manager's comment/Paul Thursby So far it has been a grim year for bonds. The degree of sell-off...
Fund manager's comment/Paul Thursby
So far it has been a grim year for bonds. The degree of sell-off we have seen is similar to the experience of 1994. But is 1999 like 1994? We think not.
It is true that the global economy is looking better, with the Anglo-Saxon economies fine and the US particularly robust. Asia looks to be moving ahead, Latin America is still struggling and Europe is finding growth hard to achieve. If Japan produces even zero growth, then a huge cheer will go up.
Commodity prices are firmer, but if one looks more closely, non-energy prices are sagging. Looking at consumer prices, there are no signs of pressure building and if we remove government-administered tax increases, core CPI would be dangerously close to zero.
In 1994 there was a growth surprise and inflation was ticking up. Now, although these pressures may grow, at the moment they do not appear to be.
Why are we so sure the dragon of inflation is really dead? The world seems to be suffering from insufficient demand. Governments ex-Japan have reached the limits in using budgetary policy to control economies.
Now the fashion is to promote growth by getting the cost of capital down and fostering competition.
We are constantly being reminded of the shortage
of quality income-producing assets - just look at annuity rates today. If we are right, the worry is that today's experience is not an anomaly but a fact of the future.
The very nature of the world is different now. Our contention that inflation is supply-driven, not demand-driven, is based on the following: globalisation, technology, deregulation, new transparency in the European market, the end of the cold war and the excess capacity evidenced in Asia.
For the time being these forces will overwhelm inflation. There are other factors too. Consumer empowerment is a new force. The consumer now makes the price - they are no longer a price-taker.
The internet is probably the most powerful deflator of all time - and it is just getting started.
It's worth looking more closely at the US. Even very modest recent increases in interest rates have dampened mortgage refinancing. Sales of homes may be easing. Job creation is slowing, but there is no let-up in job destruction, and wage rates are easing, even in the service sector. Inflation remains stubbornly subdued - there is no evidence of corporate pricing power.
The Fed may well raise rates further and probably should. Several more months of flat inflation could well see the bond market back on the front foot. Real yields at 4% - on a conservative view - makes the market good value, in our estimation. We are beginning to accumulate bonds at today's level for the first time all year.
We prefer the US at the moment but, with the recent sharp correction, European bonds are also indicating value. However, the debt explosion in Japan leaves us fearful of how the Japanese will fund their borrowings and at what rate - we think today's market levels are unrealistic. The UK is also looking tired after a long run. We are avoiding gilts for the time being.
One final thought on the recent differing performance of bonds and equities. If bonds are correct in their forecast of doom then investors need to be wary of the equity markets. In contrast, if bonds have just got themselves in a nervous pickle unnecessarily over the first half of the year, then today's levels in the US could well be a great opportunity to lock in levels that will not be seen again in a while.
Paul Thursby is fund manager at Baring Asset Management
l Supply not demand drives inflation.
l Recovery will add capacity.
l US real yields are attractive.
l US domestic demand still strong.
l Oil prices have surged.
l Gilt market looks tired.
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