Many developing economies are heavily dependent on natural resource revenue for paying their bills. The poor outlook for commodity prices in the foreseeable future does not bode well for them.
Less cash into the country means a weaker currency that will be compounded as the dollar strengthens from rising interest rates (more attractive risk-adjusted returns will drag money back to the US from around the globe).
Real yields
Emerging market debt offers broadly reasonable spreads above US treasuries, but the nominal rates themselves are very low and, therefore, moves in US interest rates will have a significant impact on real yields.
Meanwhile, the fundamental strength of developed government debt is being forgotten in the furore over rate hikes and fears of a rout in bond markets.
As the returns from bonds – already at low levels – begin to pale in comparison to higher and rising rates of risk-free return, their yields will widen to match the market rate of return.
Most investors believe bond values will fall sharply, potentially causing quite a dent in investors’ portfolios. I think the impending rate rise will not cause large falls in gilt and treasury values, so I have started to add to my direct exposure.
Contrary to popular opinion, 10- year gilt real yields are floating round their long-term average. Muted inflation makes the 2% nominal yield, which seems low, actually seem more like fair value.
Also, the path of monetary policy is expected to be elongated and shallow.
During this cycle, rates are likely to peak somewhere between 1.5% and 3%. While I expect inflation to rise, I believe dampened global demand, following the slowdown in Chinese GDP growth and the drag of a heavily indebted world, will keep inflation at around 1.5%.
That is significantly lower than the UK’s 2.7% average since 1989.
Overstated loss
The potential for large capital losses in sovereign bonds is therefore overstated, we think, and lessened by the effects of pound-cost averaging from reinvesting coupons and maturation payments – rolling reinvestment at higher yields helps offset the effects of monetary tightening.
Are gilts and treasuries the trade of the century? No.
However, they still have a valuable place in balanced portfolios to offset the risks we cannot foresee.
