There has apparently seldom been a better backdrop for bond markets than that seen in the early part...
There has apparently seldom been a better backdrop for bond markets than that seen in the early part of 2002. FRS17 is being phased in and, along with poor recent investment returns, this has hastened the demise of final salary pension schemes and boosted the attractions of bonds.
Fixed income markets have enjoyed an unusual winning streak against equities. The cumulative two-year underperformance of equities against gilts of 35.5% was the worst since 1973/74. However, there are reasons to believe that the near-term outlook for bonds will be more challenging.
The main driver of bond market performance in the past year was the steep fall in short-term rates. UK rates fell by 2% over the year and by 1% after 11 September. The interest rate cycle appears to have bottomed and the next rates move is likely to be a rise. A steady rising interest rate environment is far less supportive for bonds than a falling one.
A further positive for bonds has been the benign inflation environment. The sharp slowdown in the world economy in 2001 encouraged powerful disinflationary forces. Commodity prices fell by close to 17% over the year with oil prices also falling steeply. With economic recovery becoming increasingly evident, such a positive price evolution is unlikely to be repeated.
The global economic situation is improving. Many have commented on the unique aspects of the current economic cycle but what appears to be unfolding is normal business cycle recovery dynamics. That US household spending has remained so buoyant will mean the normal cyclical-kicker will be less than in the past. However, the more compelling factor would seem to be that the US has enjoyed a significant boost from both monetary and fiscal policy and that this is starting to feed through to the economy.
Furthermore, the stimulus from fiscal policy is not a one-off but is the first in a rolling programme. For example, the fiscal boost for FY2003 will be some $176bn, about 1.75% of GDP. The corollary of this is that government funding requirements will be higher and this will mean that bond markets will have to absorb higher issuance.
As the inventory cycle begins to turn there is growing evidence of a pick-up in global industrial production. This process is likely to reverse the disinflationary impulses so evident in the past year and the combination of a steady improvement in growth and a modest rise in price pressures will combine to ensure a higher level of bond yields.
Despite our view that bond yields will continue to move higher, the relative performance of corporate bonds is likely to remain positive. UK corporate bonds are being helped by powerful structural changes. Institutional investors, especially pension funds, are undergoing a secular shift away from equities into bonds. Furthermore, an improving economic backdrop should aid the process of balance sheet repair and improve credit fundamentals.
While debate surrounding the future of FRS17 might impact short-term dynamics, the overriding trend for a push into bonds remains in place regardless, and the credit market will remain the prime beneficiary this shift.
FRS17 beginning to be phased in.
Performance of bonds to remain positive.
Global economic situation improving.
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