Price stability favours bonds
Indicators of synchronised growth worldwide continue to pile up, including prospects for sustained growth in Euroland and surprisingly strong economic forecasts for Japan. The leading indicators suggest that growth will reach roughly 6%. Anything more seems unsustainable to us.
The year 2000 has started off very differently from 1999, as fears of deflation/ depression have given way to clear indications of synchronised growth worldwide. Most leading indicators suggest even better economic performance over the next six months than originally predicted.
This type of change in business conditions normally leads central banks to change their monetary policy. Between October 1998 and October 1999 they all adopted a very accommodating policy stance. Since October 1999, the central banks have raised their prime rates and taken back previously injected liquidity.
The reduction in liquidity threatens to weaken the equity markets. There seems to be less potential for higher stock valuations than in 1999. Overall, the background picture remains favourable with strong growth, while inflation, even if it is rearing its head, remains moderate. Although the bond markets are certainly at risk over the next few months, they should benefit over time from the central banks’ moves, which have made clear their intention to maintain price stability. Accordingly, the second half of the year should be more favourable to bonds as the first half’s sustained growth begins to moderate. The increase in oil prices and long-term interest rates in 1999, and current hikes in short-term rates, should slow the pace of growth worldwide.
On the contrary, in the US, inflation remains the primary concern. Consumer spending continues to fuel strong GDP growth, stimulated by a buoyant labour market and by the wealth effect of rising asset prices. Since this is not good for US equities, we would recommend an under-weighting. The current high level of US long-term interest rates and their volatility these past weeks reflect market concerns over inflationary pressures. A single increase may be insufficient to reassure markets, which will remain nervous until the impact of tighter money supply shows up in the economy. We would maintain an overexposure to duration and underexposure to US dollar.
In the UK, the market is expected to remain relatively unattractive until the pound begins to weaken against the dollar, and until prime rates start to peak. And the latter is unlikely before the second half of the year. Until then, we would recommend to cut back on British equities.
The minimum capitalisation requirement for British financial institutions, and the general trend towards lower equity weightings in portfolios have fuelled demand for gilts, just as supply is falling off. Accordingly, we have decided to remain cautious and return to a neutral duration exposure. Due to the pound’s correlation to the dollar, we are under-weighted sterling.
In Euroland, the recovery in world trade combined with the euro’s weakness continues to sustain economic growth. The environment remains favourable for equities, with inflation that still seems to be under control. Nonetheless, after ending the year on a strong up note, the valuations reached in certain sectors render the “-Euroland stock markets extremely vulnerable to profit warnings and disappointing earnings. Consequently, term rates are well under way. We are therefore easing an over-weighting.
The ECB’s vigilance will focus primarily on exchange rates rather than on buttressing economic activity. This will most likely translate into short-term rate hikes. However, the idea is to control the risk of inflation, which should eventually improve the bond environment.
Consequently, we will be reducing our under-weighting in bonds as a continued play on the euro’s recovery.
In Japan, although economic indicators of GDP growth remain sluggish, they hide signs of a veritable recovery. The expected effects of a strong recovery in growth are starting to emerge.
Corporate earnings are picking up nicely given operating cost reductions achieved by many firms, and investment is starting to kick in (orders for machine tools are on the rise). However, we would remain under-weighted to equities.
Firstly, the economic recovery that seems to be consolidating should push bond yields upwards. Secondly, local investors should reallocate capital to the equity markets as confidence returns. We would recommend to be under-weighted to duration and neutral to currency.
On the whole, the potential for appreciation in equity and bond prices should be more balanced this year. Consequently, the time is right to increase again the weighting of bonds in portfolios.
Didier Jug is responsible for the institutional investment department at AXA Investment Managers in Paris