International Fixed Interest – Outlook
Recent drop in government bond yields suggests there has been a variety of influences – principally heightened concerns about global economic growth, particularly in the light of weaker than expected growth data out of the eurozone, but also some general rise in risk aversion, leading investors worried about expensive equity valuations to have a greater preference for safe haven assets such as government bonds.
One positive aspect of the recent move in yields is that it demonstrates the potential value of fixed interest as an insurance policy against upsets in other asset classes. And there is also the possibility that lower than usual bond yields are becoming the new norm rather than an exception from historically higher yields. One theory in vogue at the moment is the idea of ”secular stagnation” – that long-term economic growth rates will be lower than previously and that correspondingly both inflation and bond yields will be lower than investors have been used to.
But another, and probably more realistic, way of looking at the recent moves is that bond yields have dropped to unsustainably low levels, where government bond prices look very expensive and where corporate bond yields offer at best a fair to middling reward for credit risk. It is difficult to square, for example, the current US 10-year yield with the likely rate of inflation in the US, which on consensus forecasts is likely to be about 1.8% this year and 2% next year. Forecasters reckon the mismatch will be resolved by US bond yields rising: The Wall Street Journal's latest (May) poll of US economic forecasters has the US 10-year yield rising to 3.3% by the end of the year and to 3.85% by the end of 2015. And on the corporate side, yields on the lower quality issuers now look inadequate. In the US, for example, the junkier ”high yield” debt issues now pay a little over 5%, which is unlikely to be a paying proposition over the longer term.
In some markets, there are good reasons why bond yields are likely to remain low. The European Central Bank has indicated that it may go down the same bond-buying (and hence yield suppressing) route the Fed has been following for some time and Japan is also fully committed to a policy of extremely low bond yields. Elsewhere, unless investors are in the market for expensive insurance policies against global uncertainties, bonds look to have moved into overvalued territory and the risk is that yields will rise from their current unusual levels.
International Equities – Outlook
The global economy still looks on track for a year of modest improvement in global business activity. The latest (April) JPMorgan Global Purchasing Managers Index (PMI), compiled by Markit, is pointing to global economic growth of about 2.5%. But there are question marks over how much of this growth will translate into even higher equity prices.
In the US, the data remain a bit difficult to read as the after-effects of terrible northern hemisphere winter weather are still affecting the statistics. It is probable, for example, that the reported fall in industrial production in April (-0.6%) is not as bad as it appeared as it was being compared with the strong numbers of February and March when manufacturers had been catching up with winter-affected delays. But equally it is possible that the larger than expected rise in new jobs in April (288,000) is not as good as it looks either, as hirers may have been catching up with job offers they did not put into the market earlier. Overall, however, forecasters remain reasonably confident that the US recovery is still on track, with the WSJ poll of forecasters picking 2.4% growth this year, picking up to 2.9% next year.
In Europe, the UK is also likely to do well, as it emerges, somewhat surprisingly, from a program of severe fiscal austerity with a stronger performance than had been thought likely: the UK is expected to grow by nearly 3% this year. Elsewhere in Europe, the news is less encouraging and indeed the latest GDP statistics for the eurozone were one of the proximate reasons for the recent weakness in equities and the concomitant rise in bond prices. Eurozone GDP rose by only 0.2% in the March quarter, even less than the already downbeat 0.4% that forecasters had been expecting. While Germany is doing well (+0.8% in the quarter), other major eurozone economies are not, notably France (no growth in the quarter) and Italy (a small 0.1% decline). The current consensus expectation is that the eurozone will strengthen gradually in 2015 but it remains one of the more fragile developed regions.
In Japan, the outlook is mixed. On the positive side, the government looks as if it has been able to turn deflation around: in the latest Economist poll of international forecasters, inflation is expected to be 2.6% this year. But on the negative side, GDP is responding only tepidly to what generally has been a very large program of fiscal and monetary stimulus and the economy is also dealing with the after-effects of the April rise in sales tax. The Economist poll is picking growth of only 1.2% this year and 1.3% next, a very modest outcome given the scale of government support. Investors who had bid up the Japanese share market in the expectation of a larger payoff consequently have been forced to readjust their over-optimistic expectations of corporate performance.
It is also a mixed outlook for the emerging markets. The HSBC Emerging Markets PMI is showing very little growth across the emerging markets as a whole but that is down to a mixture of poorer performance in the BRIC economies and better performance elsewhere.
The biggest questions concern China and Russia. Although forecasters are still picking quite high rates of growth for China this year and next, in the region of 7% a year, there is quite a high degree of anxiety about potential shocks to the Chinese economy from its rickety financial sector and in particular from the unwinding of a speculative boom in housing. And Russia appears to be in recession, partly due to the political instability associated with Ukraine. Elsewhere, however, the emerging markets look in better shape. Markit noted in its commentary on the Emerging Markets PMI that there is strong growth in parts of the Middle East and in central and eastern Europe (other than Russia), and there is now the prospect, after this month's general election result, that India's performance will improve under a less corrupt and more growth-friendly government.
An outlook of modest overall global economic growth (albeit with sharp regional variations), on its face, is none too bad for global equities. But share valuations are already expensive and look to be based on a stronger outcome than currently appears realistic, while there is a series of political hot spots that could also derail investors' expectations. As recent weeks have shown, investor sentiment can turn quickly for the worse and global equity markets may continue their recent zigzag pattern as investor confidence continues to wax and wane.
