The UK’s credit rating was downgraded by Moody’s from AAA to AA+, so we join France and the US in the club of recently-downgraded sovereign states. The outturn of Italy’s election was a shambles, and would at other times have caused a wave of consternation of the integrity of the euro. Sterling fell further, down 4.5% against the dollar in the month and now down by around 6% against both the dollar and the euro since the start of the year.
Realistic return outlook
Meanwhile, the MPC vote was split on an extension of the QE programme and no deal was done on US sequestration spending cuts. Yet financial markets rallied. Gilts partially recovered January’s 2.1% setback – the sharpest single monthly fall for over three years – to post 0.9% in February.
Sterling investment grade corporate bonds did a little better, the 1% return in February bringing them to broadly flat on a year-to-date perspective. Meanwhile, European high yield markets notched up a 0.5% return in the month, while the FTSE 100 equity index was up over 1% in February, after January’s 7% stellar performance.
The economic outlook for the UK provides much of the answer to the apparent divergence. Speculation on the potential for UK interest rates to turn negative was evidence enough, if any were needed, that there is little prospect of a move up in UK base rates in the foreseeable future. Meanwhile the greater inclination of the Bank of England’s MPC to contemplate a resumption of the QE gilt purchase programme underlines the fragility of the UK’s economic recovery – with growth of just 0.2% in 2012.
The fall in sterling, if maintained, while boosting the value of overseas equity earnings, evidently has inflationary consequences over the medium term which would normally be detrimental for bonds. Against a backdrop of a subdued economy and consequently little prospect of domestically-generated inflation, lower sterling is viewed more circumspectly – any fillip to the economy should help progress towards getting government finances into a viable state.
So income remains attractive and inflation concerns are held at bay. Within sterling investment-grade corporate bonds there was remarkably little differentiation in performance, whether by business sector, credit rating or maturity. The flow of new issues was moderate, and was generally well supported.
UK corporate bonds attractive
Compared to this asset class’s 1% return in February, European high yield markets were fairly subdued, posting a return of just 0.5%, being less influenced by the decline in government bond yields.
As we look ahead, despite the challenging economic conditions, especially within the eurozone, we still expect the performance of emerging countries to underpin the growth in the global economy in the medium term.
In the UK we expect the economy to remain fragile, despite the support of loose monetary policy, especially with public spending cuts still in progress. Inflation seems set to remain close to target and we do not anticipate significant domestic wage pressure.
We anticipate that UK gilts yields will rise over the medium term from their current low levels, but volatility seems likely to stay high.
We believe the present pricing of corporate bonds is still very attractive over the medium term, while their level of income generation is also appealing with the prospect of short-term interest rates staying low. Economic conditions in the UK seem likely to remain challenging and in these circumstances we believe bond characteristics which mitigate risk – structural enhancements or a claim on assets or cash flows – are an especially important aspect underlying investment performance over the medium term.
