What a difference a month makes. Less growth or more inflation - take your pick. The rise in uncerta...
What a difference a month makes. Less growth or more inflation - take your pick. The rise in uncertainty seemed to take markets by surprise and the risk premia demanded by investors increased inversely to the quality of the underlying asset.
Hence, emerging markets underperformed G7, small caps fared worse than large, and investment grade corporate bonds did better than high yield bonds. Somewhat surprisingly, corporate bonds held up well during the recent market turbulence, albeit with pockets of weakness in high beta financials and insurers. Recent months have seen significant supply in bank and insurance paper and this, as much as softer equity markets, may account for the spread widening here.
There is still strong technical demand for certain sections of the market, with an especially strong flow of funds into collateralised debt obligation (CDO) structures. In particular, bonds issued by non-financial companies continue to attract a diversity premium from these buyers, where the spread of risk by industry seems more important than strength of underlying bonds.
This is an annoyance, making arguably poor quality, riskier bonds more sought-after than their more stable counterparts. However, this theme looks set to continue. End demand for packages of bonds such as CDOs - especially from continental life companies - is not about to stop.
Unsurprisingly, as risk became a dirty word, we saw a general flight to quality. Gilts performed strongly, helping most UK bond funds post a positive total return over the month.
While Aegon still believes selecting names rather than rotating country allocations will create more value within markets, it is instructive to assess each market's relative merits. The recent underperformance of the euro market relative to its sterling and dollar counterparts, combined with the relatively weak short-term technicals of the sterling market, makes a case for any new money for investment grade to be allocated to European investment grade.
It is likely the European Central Bank will act to control inflation, which ultimately should support the price of fixed interest assets. The jury is still out whether the US equivalent is ahead or behind the curve and therefore allocation to Europe rather than US holds appeal.
Until equity volatility (probably best represented by the VIX series) subsides from its current highs, investment grade returns will likely remain choppy. The thin break-evens (the number of basis points a corporate bond's spread can widen before the total return is less than that from the risk-free asset) offered by current spread levels do not encourage more risk, unless there is a market blow out.
Moving into the summer period, the main driver for most markets seems to be the possibility of the Fed raising US rates again. Fed chairman Ben Bernanke appears no more beneficent than former chairman Alan Greenspan, contrary to initial expectations. Going forward, unless economic data falls off the proverbial cliff between now and the next Federal Open Market Committee meeting, scheduled for 8 August, a further rise in US interest rates is inevitable.
The question for the market has to be more about the statement of future intent.
Corporate bonds held up through uncertainty
European Central Bank likely to control inflation
Hawkish past, neutral present, dovish future
An ambitious objective
'Something completely new'
'Illusion of control'
Reasons to be cheerful
Total investment reaches £9m