Following hard on the heels of a significant rally in the gilt market, talk of a turnaround in the...
Following hard on the heels of a significant rally in the gilt market, talk of a turnaround in the global economy has sparked the debate over whether the lean winter months for the equity investors are finally drawing to an end. Indeed, we have begun to see tentative signs of a recovery in corporate earnings and the equity markets have rebounded well from their September lows.
We anticipate a gradual return to trend growth for the UK economy and we expect the Bank of England to begin tightening monetary policy in the second quarter of 2003. For these reasons we are confident of our forecast for rising yields over the longer term.
However, short-term risks are not quite as easy to ascertain with the same degree of confidence and are likely to underpin bond prices. Economic fundamentals remain mixed at best. Equity market volatility levels are high. The pending war with Iraq has placed an additional safety premium in gilt prices.
Thanks to robust consumer spending, the UK economy has held up well relative to its peers. The UK housing market is, in our opinion, one of the key variables likely to impact on the UK economy going forward. A slowdown on the housing market will lead to a slowdown in consumption growth and the eventual re-balancing of the economy.
A slowdown in consumption growth would almost certainly raise the prospect for another rate cut and increases the possibility of a further decline in yields, particularly at the short end of the curve. While longer-term economic fundamentals may favour a weaker bond market, technical factors remain supportive. With an ageing population and increased life expectancy, pension funds will have to place a larger portion of their assets in bond markets to ensure they are able to generate sufficient returns in order to meet their liabilities. The press has been inundated with stories of pension fund solvency concerns following significant equity markets declines and this will see asset allocation trades continuing to favour fixed income markets going forward.
Ironically, an equity market recovery could accelerate this trend, as many institutional investors are waiting for more favourable equity prices before executing the switch into fixed income. Another factor worth bearing in mind is that in addition to the obvious benefits of generally accepted lower risk profile of fixed income assets, active fund managers have a variety of sources of outperformance at their disposal.
As well as the more traditional duration and yield curve strategies, active managers have the ability to undertake asset allocation trades in corporate, inflation-linked and international bond markets, allowing them to add value under a range of market and economic circumstances.
Corporate bonds will benefit from an improvement in economic growth and a recovery in equity markets. Index-linked gilts, whose coupon and redemption payments are adjusted for inflation, will offer protection against increases in general price levels as the economy recovers, while international bonds in many cases offer more attractive valuations than UK gilts.
Economic fundamentals remain supportive.
Asset allocation trades underpin the market.
Excess return available to active managers.
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