Government bonds are unlikely to deliver strong returns in a low interest rate environment going into next year, warns Jupiter CIO John Chatfeild-Roberts.
The manager of the group's Merlin multi-manager range says while the asset class has attracted significant inflows this year, income investors face difficult choices in 2011 as interest rates are likely to remain low and the potential for bonds to produce further gains looks limited.
Chatfeild-Roberts says: "It has been another strong year for bond investors but the risks associated with holding these assets are increasing. Government debt looks particularly vulnerable with the yield on US treasuries blowing out from 2.51% to 3.28% last week on the back of a new stimulus package aimed at boosting US growth and better economic data.
"This has come on the back of sharp rises in yields this year for debt-ridden eurozone countries such as Greece, Ireland, Portugal and Spain and investors should expect volatility to continue into 2011.
"Investment grade corporate bonds are also looking less attractive. While companies are generally in pretty good shape, their bonds are vulnerable to increases in government bond yields. Opportunities remain further down the credit rating spectrum but investors need to be very selective and focus on protecting against downside risk."
The manager adds yields on equities look more attractive in many cases, and although equity income funds have underperformed growth funds for some time, they may prove a better option for income-seekers than all but the most flexible of bond funds.
Meanwhile, turning to the economic outlook for the UK, Chatfeild-Roberts says he is not as pessimistic as some on the country's growth prospects.
"While the UK economy faces significant headwinds as the government imposes spending cuts, there are some encouraging signs of growth; the manufacturing sector, for example, expanded at its fastest pace for 16 years in November.
"Furthermore, companies are, in many cases, extremely profitable and so profits growth may be better than many expect. I am also more positive on the US and while growth across the pond will not be of emerging market proportions, it should be adequate."
He also expects emerging markets to continue attracting asset flows in 2011. Chatfeild-Roberts says: "There is no doubt many emerging markets have lower debts and higher growth rates than the Western world and are assuming a greater role on the world stage.
"This transition will provide some excellent investment opportunities. As economies develop, there will be increased demands for the building blocks of that development, such as raw materials.
"The emergence of billions of new consumers has the potential to benefit well financed companies with desirable western brands and powerful distribution.
"However, the transition for emerging markets will not always be a smooth ride. How these countries manage their growth, especially in the face of so much liquidity looking for a home, is as important as the way in which the West tackles its structural deficiencies."
Investors also need to be alive to potential consequences of a ‘new world order' in currencies emerging, as countries that peg their currencies to the US dollar are preventing the natural rebalancing that would otherwise take place, the manager says.
"It is entirely possible that for some countries the dollar peg will break down, leading to an appreciation of their currencies against the dollar. This would result in more expensive imports for the West, but give greater purchasing power to consumers in those countries. It would also be beneficial in currency translation terms for Western investors in emerging markets.
Chatfeild-Roberts remains positive on the outlook for gold while interest rates remain low. He says: "The opportunity cost of holding gold is not high while interest rates remain low and with the world outlook remaining relatively uncertain, I continue to believe it makes sense maintaining exposure to the asset class."
Industry Voice: Scottish Widows pension expert Robert Cochran and economist Andrew Scott discuss the future of employment and income, in episode three of Scottish Widows' podcast series.
What made financial headlines over the weekend?
Follows McVey's resignation
Schroders and Aviva Investors
LightTower Partners, Seneca Partners and Unicorn AM