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Bond Bulls are an Increasingly Rare Breed

ECONOMIC & MARKET BACKDROP: There is a growing sense of optimism in global economic commentary

Andy Brunner 11 February, 2013 | 5:41PM

While still couched in fairly cautious terms, there is a growing sense of optimism in global economic commentary. This follows a year in which financial conditions and confidence were severely undermined by major “tail risks”, any one of which occurring could have derailed the global economy. Policy actions have averted any extreme outcomes and there is far less concern today that a euro breakup, a US fiscal debacle or a Chinese hard landing could occur this year. To be sure, none of these issues has been fully resolved but improving confidence is patently obvious when commentators begin to ask when the US Fed should consider taking away the punchbowl.

A comment from the BBC’s economics correspondent, Stephanie Flanders, perhaps best sums up the prevailing sentiment; referring to the annual World Economic Forum held last month in Davos, where central bankers, business leaders and politicians gather for four days to discuss and debate the challenges facing the global economy, she noted that Davos wouldn’t be Davos if people weren’t constantly talking about the need to avoid complacency – "but this was the first time in five years that there seemed a genuine risk of it breaking out".

During January, the IMF also produced its quarterly Update to the World Economic Outlook but, true to form, warned that "downside risks remain significant, including renewed setbacks in the euro area and risks of excessive near-term fiscal consolidation in the United States. Policy action must urgently address these risks". No complacency here then!

In the real world, several Q4 GDP reports were released revealing economic contraction in the UK and, more surprisingly, the US, thus ensuring Q4 was the worst quarter for global growth since the recovery began in 2009.

As noted many times, however, as often as not headline GDP figures hide more than they tell and, indeed, the very poor US number concealed a strong upturn in private sector demand. Data suggests that the developed economies have contracted by around 0.5% but, as a result of a strong pick-up in the developing countries, particularly China, a fall back into real recession will be avoided with growth of around 2.5% being classed a “growth recession”.

Looking forward, global growth will likely remain subtrend in Q1 and in all likelihood a more significant upturn will not become apparent in headline GDP until the second half as improving financial conditions and confidence gradually feed through. The latest estimates for the main economies from the leading investment houses are shown in the following table:

(Click image to enlarge)

While the above forecasts show mixed GDP trends across the main regions/countries for 2013, the key point currently being discounted in financial markets is the marked acceleration expected as the year progresses. As already discussed, Q4 2012 was generally very weak, but for Q4 this year most commentators have penciled in a significant upturn in the rate of growth with global activity prospectively running at an above-trend pace.

While underlying growth in the US economy is far stronger than headline figures suggest, it is still some way short of returning to "sustainable expansion" i.e. when the economy attains a virtuous circle of private sector growth, with stronger consumption producing increases in capex and hiring, generating higher incomes, etc.. 

For Q4 2013, the Bloomberg consensus estimate is for the US economy to be growing at a 2.7% p.a. rate and, with government spending generally expected to be negative contributor, this indicates a growing belief in "escape velocity" being attained.

There is no such hope for the euro area or the UK, the former will be happy enough just to be out of recession by year end, while the latter remains burdened by ongoing government spending cuts and high levels of inflation eating into real incomes, sufficient to prevent anything more than a weakish cyclical upturn.

Go east remains the call with, at least this year, the Japanese economy boosted significantly by “Abenomics”. Prime Minister Abe’s new LDP administration has announced a massive public sector spending programme and persuaded the Bank of Japan to adopt a 2% inflation target and agree to open-ended asset purchases that has generated a near 15% devaluation of the yen. Systemic reform, however, is the missing piece of the jigsaw.

The Chinese economy is still benefitting from prior stimulus and should continue to accelerate through mid-year. Most of the Asia region is experiencing an upturn in industrial production and exports on improving Chinese and US economic fortunes.

Naturally enough, improving economic data and sentiment and the downplaying of prior "tail risk" concerns were not lost on the financial markets in January. Equities surged, with the MSCI World Equity index recording the best January rise in 19 years; that was also the largest monthly gain outside of recovery rallies since 2010. Global index gains were led by the Japanese TOPIX index, albeit at the expense of substantial currency weakness. In common currency terms most areas performed fairly similarly, although euro strength pushed European stocks to the top of the performance tables once again.

From an economic sector and market capitalisation size perspective, there were no clear trends favouring specific types of sectors or size of company, indicating a generally universal push into stocks. Indeed, volumes were up sharply as volatility fell and flows into equity funds reached their highest four week total since April 2000.

A "great rotation" into equities is still wishful thinking but there is no doubt bond bulls are an increasingly rare breed. As a risk asset, high yield bonds are still performing well as investors continue to search for higher income but losses were sustained in both government and investment grade bonds. The losses on longer dated maturities, in particular, are building up and, as equity markets have soared 15% or so over the past six months, the Bloomberg US Treasury 10 year plus bond index has lost 8%.  The scale and timing of this relative equity gain is perhaps indicative of a trend change as prior moves of similar magnitude in recent years have all been "relief rally" driven.

Elsewhere, commodities were led higher by the energy and industrial metals sectors on improving economic data, while gold needs to break above $1,700/oz. to regain momentum.  Momentum has certainly driven the forex markets, at last allowing traders/speculators to make money, but this also tends to lead to unsustainable positioning. Over the month the biggest move was euro/yen with the euro appreciating 9% and bringing forward the timing when "currency wars" becomes a bigger debate.

UK commercial property values fell again, but at a slower pace, and there are straws in the wind that the downturn may draw to a close as the year progresses. While UK institutions may not yet be aggressively raising property weightings to access the 7% yield available (compared to 3% on 20-year UK gilts), there are a large number of overseas pension funds and wealth funds that are drastically cutting back on government bond exposure in favour of commercial property.

One of the biggest issues facing investment managers today is the very low yields on bonds; 10-year governments are already at or below 2.0% and investment grade and high yield both hit new all time lows in January. For a 50:50 equity/bond fund where, on average, 50% of it is only likely to return just 1.5%, this exerts enormous pressure on returns from the other 50%. If targeting returns of say 7% to 8%, a 6% contribution from equities is required which means equities need to return 12%, a level way above the long term average. This creates a considerable dilemma, especially for lower/medium risk funds, that have been able to generate a significant proportion of their returns from bonds in recent years.

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About Author Andy Brunner

Andy Brunner  is an investment strategist with Morningstar OBSR.