Not only do bond investors disagree among themselves as to the direction of interest rates this year but the asset allocation pundits are also proposing a variety of outcomes. For Goldman Sachs, for example, the place to be over the next 12 months is equities: “Equities offer the best returns: we remain overweight equities and convertibles, neutral cash and commodities and we are underweight bonds. Over the next 12 months we forecast a 19% return from global equities, 13% from convertibles, 5% from bonds and from commodities and 3% from cash.”
Others, drawing comparisons between 2002 and 1994, worry that this year could turn out to be a dreadful one for bonds, and indeed other asset classes. Some have gone back a bit further to find the clues.
CSFB’s Jonathan Wilmot and Paul Mielczarski, on the other hand, have come up with a scenario that, while it agrees equities initially are the asset of choice in today’s recovering economy, corporate bonds could overtake them. “During the early 1990s recovery, slow growth, poor pricing power and deleveraging produced relatively good absolute (and even better risk-adjusted) returns for US credit. There are reasons for thinking that the current cycle will produce a similar outcome.”
They go on to suggest that with equity valuations and credit spreads still high, and doubts about both pricing power and a strong profits recovery, corporate bonds could offer a better recovery play than the more usual choice of equities. “The sluggish recovery of 1991/92 featured a much briefer and more modest period of excess equity returns than usual. Corporate bonds typically match or exceed equity returns for an extended period once rapid recovery gives way to expansion.”
In the 1991–93 recovery, not only did the weaker investment grade credits and high yield outperform, but even high grade credit returns kept pace with equities, and outperformed on a risk-adjusted basis (noting that over the past 16 years, equities have been typically 1.5 to 2.5 times more volatile).
The analysis surmises that it may be a little too early to shift from equities to bonds overall, given that the recovery should still be strong over the remainder of the first quarter – which should continue to be good news for equities.
They point out that there are some major differences this time around, such as the fact that Japan has been in a slump for 10 years, that the US dollar and banks are so much stronger and even the arrival of euro notes and coins. However, in conclusion they highlight that there are enough similarities in valuations, balance sheets and likely growth trends to suggest that similar assets – the unusual combination of long bonds, emerging assets and credit – might produce outperformance similar to that of the early 1990s.