Since the end of the Iraq war we have witnessed huge gains in the markets for equities, emerging markets debt and high yield bonds. A significant reduction in the risk premiums on the various assets is the main reason for this exorbitant performance. The equity premiums can not be observed directly in the market. But the narrowing of credit-related spreads in the bond markets can be directly read. The narrowing of credit spreads is balanced by an improved credit quality and is not the result of irrational exuberance. Improvements in earnings conditions have played a minor role in the attribution to performance in the equities markets.
Looking forward, we expect that this situation will change and the focus to be on the profitability of companies. Risk premiums will more or less stabilise around present levels. We are convinced that the US will be able to lead the global upswing with China catching up. In Japan there are signs of improvement but it is still difficult to gauge. Europe is still the weakest link. The problems here are both cyclical and structural. The political commitment to implement structural reforms in Europe has increased recently, which is a positive factor longer term for European equities.
The spectre of deflation, paving the way for unsustainable low yields on long-term bonds, has haunted the bond market. Since the beginning of June we have seen a correction in yields after stronger fundamentals and changed central bank rhetoric. The present level of interest rates is more in accordance with the underlying fundamentals. Short term the risk for significant higher interest rates is diminutive, as the yield curve is rather steep. The economic upswing is led by productivity gains and not job creation. With little evidence of inflationary pressures or a recovery in employment, it unlikely that central banks are rushed into tightening monetary policy until next year. But it will happen, as inflation would return in the second half of the current decade as labour markets become tighter and wage inflation kicks in. We have to get closer to a tightening of monetary policy before we can expect a steeper yield curve. A flattening due to a tighter monetary policy will follow this. But longer-term the trend in yields is upwards all over the curve.
This scenario favours credit-related assets as equities, emerging markets debt and high yield bonds. Therefore overweight equities to bonds. Among the equities we favour emerging markets based on valuations and economic outlook. In the Far East especially China offers good value for its prosperous growth outlook. A weakening dollar will facilitate growth in China, and a revaluation of the renimbi will be inevitable. But manufacturing in China will still have a competitive edge. In Latin America the momentum in the transformation of Brazil still has a way to go with a positive impact on the local equity market.
Emerging market and high yield bonds offer good value compared to government bonds. Convergence towards investment grade will still be an issue in the bond markets. As long as narrowing of the yield spreads in these markets is matched by better economic fundamentals the risk characteristics is unchanged and further improvements will lead to even lower spreads to government bonds. Longer-term return expectations for different asset classes are shown in the figure. The expectations express an average return over a 10 year investment horizon and are based on the expected development in the interest level, risk and credit premiums. It should be emphasised that short term expectations may deviate significantly from these long-term mean expectations.
The correlation between prices in the equity and bond markets has been negative for a long while as result of flows between the different asset classes. This will probably also be the case in the near future but the relation may differ in the future. In an environment with more stable risk premiums the role of the interest rates will be more of financial valuation. The diversification characteristics of different asset classes may differ in the future compared with what we have become used to in the most recent history. It is therefore important to include subjective risk as well as objective measures in the asset allocation process when optimising and constructing portfolios.
Niels Skovvart is chief investment officer of Sydinvest in Aabenraa, Denmark

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