EUROPE – Demand from pension funds will be one of the factors behind European bonds outperforming next year, according to Merrill Lynch.

It said that “positive fundamental trends” in European economies would couple with demand from pension funds and low inflation – resulting in Euro bonds performing best in the next 12 months.

“Positive fundamental trends in Euro economies are likely to be manifested in the relative attractiveness and outperformance of Euro bonds,” the firm said in its outlook for 2005.

“A dominant driver of Euro bond performance is likely to be the strength of the euro. Ongoing reallocation by central banks into the currency is expected to provide strong investment demand in Euro bonds.

“This, coupled with demand from pension funds and low inflation, is expected to result in Euro bonds performing best in 2005.”

It said that stable global interest rates, slowing growth, and low inflation in the US and Europe would probably mean a low-volatility environment for bonds in 2005. Merrill called this situation the ‘New Normal’.

Merrill also said that companies have now repaired the damage to their balance sheets – caused in part by pension deficits. Balance sheets were now “bulging with cash and free cash flow generation is strong”.

The firm said: “This is prompting more and more companies to return cash to investors in the form of dividends and stock repurchase activity. We expect this trend to gain momentum as 2005 progresses.”

And it told investors to concentrate on higher-quality assets of companies with excess cash, and become more defensive and more diversified across asset classes and regions.