The question for bond investors is whether or not the credit rally and the sell-off in government bonds so far this year has been too much given the global macroeconomic fundamentals and the risks that remain.
We are where we are…
Our core view of positive yet low global growth, limited inflation, stable interest rates and significant remaining risks is arguably a very positive one for bonds. My angle is there is enough variety in global bond markets to find interesting investment opportunities. Yet valuations may start to become a problem.
Over the past decade an aggregate global bond index has performed at least as well and probably better than a representative global equity index, with significantly lower volatility. In fact, a more diversified bond portfolio than the standard government and investment grade aggregates would have done even better. I know all the studies tell us that equities deliver higher returns over the long run and still the culture of growth through equities remains very pervasive, but the evidence of the past decade does not support that thesis.
So why might it be different over the next decade?
Here is where the valuation aspect comes in. Bonds might just be too expensive. Of course, people have said that for ages but we are at very low levels now. Yields on core government bonds got down to 2% (or less) recently and credit spreads have already narrowed a lot in 2012. The yield on the Bank of America/Merrill Lynch Euro corporate bond index is just 3.2% currently.
Even in high yield, the outright yield has come down a lot. Yes, relative to almost zero returns on cash, fixed income yields may still look more attractive, but in comparison to what we hope will be rates of nominal GDP growth in the future and to the current earnings yields on equities, bonds do look expensive.
Relative equity/FI valuations
The "sell bonds/buy equities" trade would clearly have been even better at the end of November last year. Today, equities are higher but the relative valuation may still work for some investors.
The provision of liquidity by central banks and the strong fundamentals of the corporate sector are drivers that should continue to work for global stock markets, as well as corporate credit. For the foreseeable future, the total return from investment grade credit is probably low single digits given the potential for underlying yields to rise and the limited scope for further credit spread narrowing in the non- financial part of the credit market.
For government bonds a big round zero or worse is likely in the year ahead. For high yield there is still scope for more attractive returns, but increasingly the cushion of support for a potential increase in default risk at some point will diminish. Will equities do better? I will leave that one for you to all ponder. I guess it comes down to confidence in economic growth.
There are plenty of risks in the outlook, though I suspect some of the recent market action is related to profit taking ahead of the end of quarter.
