Global economic activity is picking up, led by the recovery in Asia, and central banks are moving to...
Global economic activity is picking up, led by the recovery in Asia, and central banks are moving to reverse the dramatic relaxation of monetary policy that they implemented a year ago.
In the US, the economy has maintained its robust growth rate; in the UK, forecasts of GDP growth are being revised upwards; in Europe, there is growing evidence of recovering activity and rising business confidence in the core economies of France and Germany.
The US Federal Reserve had already raised US interest rates by 0.5% to 5.25% during the summer months, in October, left rates unchanged but moved up 25 basis points last week. The Bank of England Monetary Policy Committee raised UK interest rates by 0.25% in September, and has done so again in November. The European Central Bank also raised euro rates in November by 0.5% from 2.5% to 3%, reversing its rate cut of last spring. Both moves were broadly in line with market expectations and it seems not unlikely that, once millennium uncertainties are out of the way, we will see further interest rate rises.
These interest rate hikes have reassured bond markets of central banks' commitment to the control of inflation, and have prompted a strong rally in bond markets, particularly in long-dated bonds. Although this is probably no more than a technical correction from an oversold situation, and seems unlikely to presage a longer-term rally, we do not see this year's bear market as having a great deal further to run.
Real interest rates have now returned to their five-year average, global capacity utilisation rates are not inflationary, and global competition remains strong. Technological developments and the internet are strong disinflationary forces, with the latter providing an increasingly pervasive influence that not only permits, but also compels, more efficient pricing at all stages of the manufacturing and distribution chain.
At the same time, government fiscal policies are generally prudent; unofficial over production by Opec members should contribute to a weakening oil price; and the cost of borrowing whether corporate or personal is approaching levels in the US that should have some dampening effect on its economy. Finally, but not least, bond markets have already priced in further interest rate rises.
In such an environment, prospects for capital appreciation are limited and income is likely to be the most important element in total return. We continue to prefer credit risk, or yield, to government bond risk, and remain very optimistic about the European high yield market, where several factors suggest we are at the early stages of strong growth.
The growth of an equity market culture has focused attention on the need for corporate management to maximise return on shareholders' capital. Rather than sitting dormant on the balance sheet, capital will more often be raised when needed, on a more project-specific basis. At the same time, unwanted businesses will be spun off or disposed of, creating opportunities for management buy-outs and debt issuance. Similarly, deregulation (for example, in telecoms) is providing opportunities.
In the meantime, tight fiscal policies mean that government borrowing is not crowding out corporate issuance. European banks remain under pressure to improve return on capital by reducing assets, and are shifting away from capital-intensive lending towards fee-based services, thereby providing opportunities for credit markets to provide the finance direct. Finally, European M&A activity is at record levels, generating demand for new bond issues to finance acquisitions.
Paul Causer is fund manager at Perpetual
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